Outlook Bullish: 2nd Mortgage Capital Markets Slowly Strengthening

By SAM GARCIA

 

Updated 6:58 am Pacific August 16

 

Activity in the capital markets for second mortgages has yet to return to its pre-2008 levels as the sting of the financial crisis remains fresh with investors 15 years later. More securitizations are closing, though they are not easy, and the outlook for issuance going forward is bullish.

 

2008 to 2019

Issuance of residential mortgage-backed securities that contained junior-lien home-equity loans and lines of credit came to a screeching halt following the financial crisis and has never fully recovered. That is because of low supply and low demand, according to Jack Kahan, senior managing director at KBRA.

“On the demand side for securitization, many market participants recognize junior liens originated during and prior to the GFC (great financial crisis) as having meaningfully underperformed,” Kahan wrote in a statement to HELN. “The credit attributes, and the layering of such risky attributes, such as high CLTVs, lower FICOs, and less than full documentation led to some of the worst collateral losses observed during the GFC.”

Kahan noted that on the supply side, cash-out junior liens were limited for the past decade as rates were historically low, and borrowers with home equity could obtain first-lien cash-out refinances.

“Only recently, now that mortgage rates have risen precipitously, has the first lien cash-out refinance option essentially vanished for many borrowers even though borrower equity generally remains untapped,” he added.

Fitch Senior Director Ryan O’Loughlin attributes the inability to rebound to a lack of origination volume.

“There has been limited incentive for these loans since the financial crisis,” O’Loughlin said in a written statement to HELN. “The GSEs will typically allow loans with LTVs up to 97% (or higher in some instances), which severely reduces the need for a second lien at purchase.”

Figure Technologies Inc., which has been at the forefront of home-equity issuance with a product that utilizes blockchain in its automated underwriting, has faced two challenges.

The first was how much players in potential transactions needed to be educated, Franco Li, head of capital markets for Figure Lending LLC, explained in a recent LinkedIn event, 2nd Lien Originations and Capital Markets Liquidity Support, hosted by Computershare Loan Services Senior Vice President Ralph Armenta.

Li said that when the company, founded in 2018, first marketed to initial investors, they asked what a second lien was and had to explore how to analyze the risk. They also had to consider how rating agencies viewed junior liens and Figure in terms of servicing.

The second challenge Figure faced was that its underwriting utilizes technology that is novel to most traditional investors and lenders.

Spring EQ, which relies on financial institutions, insurance companies, investment funds and issuers to acquire loans, faced similar hurdles when they first approached investors, the lender’s CEO, Jerry Schiano, explained during the LinkedIn event. They had to convince loan buyers that the quality of their paper was better than that of pre-crisis home-equity loans, which performed horribly.

Brian Brennan handles whole loan trading at Saluda Grade, which says it invests “in emerging asset classes inside the U.S. real-estate sector that present attractive risk-adjusted returns with alpha opportunities across liquid and illiquid strategies.” He commented during the webinar that when he worked with Figure and Spring EQ early on, the small investor base had more of a “clubby feel.”

 

2020 to Present

Trez Moore, head of capital markets at Georgia Banking Co. — which sells some of the loans it originates mainly to community banks — said during the LinkedIn webinar that there has recently been softer demand for second-lien loans from community banks.

“Recently, yes, there’s less interest, there’s less of them, they’re more conservative on their pricing,” Moore explained. “But, frankly, I also expect to sell a decent size pool to a community bank tomorrow. So, it’s not gone away, [there’s] just less of it.”

As banks’ solid grip on funding second mortgages starts to wane, residential mortgage-backed securities transaction volume has begun to pick up. HELN has tracked nine home-equity transactions so far this year.

Fitch’s O’Loughlin noted that the firm has seen a pickup in the volume of junior-lien transactions this year. Behind the uptick are consumers’ economic dynamics as first mortgage refinances remain rate prohibitive.

“A substantial majority of mortgages have a current interest rate at or below 4%, while current market rates are north of 7%,” O’Loughlin explained. “It is not in a borrower’s best interest to refinance their loan and take cash out at the higher rate when they can instead keep the low rate on the first lien and instead take out a second lien even if it has a rate closer to 10%.”

But the transition from a market where banks predominantly finance second mortgage production to one where RMBS investors finance a larger share of originations is a painful and slow journey.

“The capital markets on home-equity loans is not like the capital markets on traditional first mortgages where there’s Fannie, Freddie and Ginnie,” Spring EQ’s Schiano stated. “The capital markets here is something that you have to develop every day. They’re not as stable.”

He explained that he never had to worry about originating too much paper for the government-sponsored enterprises when he previously worked in the first mortgage business. But in the second mortgage business, that is always a concern.

Saluda Grade’s Brennan highlighted Figure’s deal this year that was rated by two rating agencies. He said that as a result of that transaction, they have seen more interest from a broader investment base. The company went from a small pool of investors “to being asked to get on 40 to 50 calls and starting to explain how this product works and how the securitizations work.”

Recent ratings downgrades for the U.S. and banks, along with deflation in China, haven’t significantly impacted junior-lien transactions, which have held up well.

One new product, a home-equity line of credit that is tied to a credit card, is struggling to find capital markets support.

Valerie Kay is the head of capital markets at Aven Financial, which offers a HELOC credit card. In the online event, she said that financing for the product is challenging and  difficult due to the cash flow complexities associated with the draws.

However, Aven has recently partnered with a financial institution to offer the HELOC-linked credit card.

 

Outlook

Looking ahead, Schiano said, “The key to this market [will be whether we can] develop [a stable] capital market and serve the customers.”

Fitch’s O’Loughlin expects an increase in traditional home-equity transactions going forward.

“HELOCs/CES (closed-end seconds) have been hot topics with originators, everyone is focused on originating these loans and there is a customer base as borrowers look to tap the equity in their home to pay off other debt (student loans) or just take their money out prior to home prices being impacted by the upcoming recession expected in 2024.” O’Loughlin wrote. “Investors like these loans for the yield, so there is demand to securitize and incentive for the banks to securitize them especially since banks will not be able to hold as much on their books if the new BASEL rules come into play.”

Figure’s Li expressed optimism about the sector.

“We’re pretty bullish in general that, as folks understand this asset class further, and our securitization and other securitization programs further, there is some insulation, I’d say, to kind of the broader noise around geo and macro risks,” he said.

Brennan said that investor reception has been good, and he expects that to continue. From an investor standpoint, he sees this product becoming increasingly commoditized.

KBRA’s Kahan expects growth in the number and volume of second-lien securitizations over the next year.

“The level of untapped home equity provides a base for borrower demand and the successful, if limited, issuance to date suggests that securitization as one financing source is viable, at least currently,” Kahan said in the statement. “That can be a signal to originators, and loan aggregators, to pursue greater issuance volume.”

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