Government-sponsored enterprise (GSE) Freddie Mac has put its finger on the scale of an emerging loan market that has been the domain of the private-label securities market, which has nurtured its reemergence in recent years.
Last month, Freddie Mac announced a plan to begin purchasing single-family closed-end second (CES) mortgages from lenders, a proposal now subject to a public comment review period before adoption.
As of now, the agency’s proposal calls for keeping the CES loans in portfolio for six to nine months until it can develop a system for issuing second-mortgage guaranteed securities against the loans, which would carry 20-year fixed-rate terms. Credit-risk transfer vehicles “would be evaluated in subsequent phases,” according to an outline of the proposed Freddie CES plan issued by its governing body, the Federal Housing Finance Agency (FHFA).
Peter Van Gelderen, co-head of Global Securitized at TCW, a leading global asset management firm, said this means there could potentially be two new and unique products unveiled on the agency side: CES loan purchases and a related credit-risk transfer product designed to shift some of the agency CES risk to private investors.
“In the current housing market, marked by higher mortgage rates, low housing supply, and continued year-over-year house price appreciation, existing borrowers face limited options to access their home equity, especially for the many homeowners who purchased or refinanced their homes during a period of lower mortgage rates,” Freddie Mac spokesperson Chad Wandler wrote in an email to HousingWire to announced the planned loan program.
“Also, a traditional cash-out refinance today may pose a significant financial burden, as it requires a refinancing of the entire outstanding loan balance at a new, and likely much higher, interest rate. Freddie Mac proposes to purchase closed-end second mortgages on properties for which it already holds the first mortgage so homeowners can keep the same mortgage interest rate on their primary mortgage. This provides homeowners with a cost-effective alternative for accessing the equity in their homes.”
The announcement immediately drew criticism from the Structured Finance Association (SFA), which has some 370 member institutions that include broker/dealers, investors, securities issuers, various financial intermediaries, rating agencies and more.
“I don’t understand what problem Freddie Mac — and I’m almost certain Fannie Mae to follow — are solving, because the private market is already filling this space,” said Michael Bright, CEO of the SFA. “And it’s been filling it increasingly efficiently over the last couple of years and has plans to continue to do so.
“So, it feels a little bit like the 800-pound gorilla inviting itself into the room and saying, ‘Oh, we want that too.’”
With respect to Fannie Mae’s potential entry into the second-lien market, the agency provided the following comment to HousingWire: “Fannie Mae is closely monitoring market feedback and will continue to work with FHFA, and Freddie Mac as appropriate, on any future developments.”
Growing market
Since the end of the global financial crisis some 15 years ago, more than 100,000 second-lien loans with a total value of about $8.7 billion have been securitized in the private-label market, “of which $4.5 billion were CES [closed-end second liens] that are subject to the [Freddie Mac] proposal,” according to a recent report by the Kroll Bond Rating Agency (KBRA).
CES originations represent a small but fast-growing portion of the overall private-label securities (PLS) market, with all of the post-crisis CES-backed securities issued since 2020.
The potential market, however, could be much larger over time. KBRA pointed out that at least $185 billion in second-lien loans were securitized prior to the financial crisis.
KBRA data shows that, year to date through mid-May 2024, there were eight PLS offerings backed entirely by CES loans, with a total value of $3.2 billion. That compared with only five offerings for $1.6 billion in total for all of 2023.
The CES-backed deals so far in 2024, according to KBRA’s tracking data, have been offered through shelves sponsored by Rocket Mortgage, J.P. Morgan and Saluda Grade.
“The biggest concern we get on seconds [CES loans] is having a reliable outlet in the secondary market,” said John Toohig, the head of whole loan trading on the Raymond James whole loan desk and the president of Raymond James Mortgage Co.
“A lot of mortgage companies and even depositories want to make them [CES loans], but they want to know the right structure and underwriting, and they do not want to make a loan that they will get stuck with.
“Enter the GSEs. This [Freddie plan] could create a common structure and a uniform underwriting guide to help standardize the sector.”
One concern with Freddie Mac dipping its toes into the CES market, according to Toohig and KBRA, is that it could skew the existing PLS market toward riskier credit.
“Assuming both GSEs were active in CES purchases, nearly 60% of the CES originated and securitized in today’s PLS market might have been eligible for [the] GSEs’ proposed program,” KBRA reports. “…The PLS market could end up with a larger share of CES with more negative credit attributes and is likely to become more concentrated with home equity line of credit (HELOC) products.”
Bright said that Freddie’s CES proposal would help homeowners extract home equity, adding that he doesn’t see how that applies to the agency’s core mission of helping to “provide affordable credit for low- and moderate-income homebuyers.” He stressed that “if anything, it could be a negative for their core mission.”
“In my view, they have not articulated what market failure they’re attempting to solve here,” Bright said. “And so, it does feel like combination of them wanting more market share, of course, and more business.”
Bright also worries that in the current high-rate environment, in which a huge portion of the market is locked into rates below 4%, expanding access to home equity financing via Freddie (and possibly via Fannie as well) will only make more homeowners less likely to sell their homes.
“What we need now is more people willing to move and sell their homes, but they’re not doing that because of the rate lock-in effect,” Bright added. “I don’t see how this [Freddie CES plan] would in any way help that and, in fact, I could see how it would exacerbate that problem.”
Hockey pucks
Van Gelderen of TCW doesn’t see expanding access to home equity as a real concern, adding that it’s a case of “looking at the hockey puck instead of where the hockey puck is going.”
He points out that the blended rate of a low first-lien mortgage and a much higher second-lien mortgage is going to move that homeowner closer to a refinancing rate trigger, not further away.
“So, it will generate transaction volume in the short term [via more CES originations] and, in the future, it also likely generates more refinancing transaction activity as mortgage rates normalize,” he said. “…The housing industry is a business that produces loans where there’s no loans to be produced now, and so this [Freddie CES plan] could possibly catalyze greater origination.”
Ben Hunsaker, a portfolio manager focused on securitized credit for Beach Point Capital Management — a multibillion-dollar investment management firm — said that Freddie’s plan to enter the CES market, if it pans out, would likely cannibalize some of the business that could have gone through nonagency markets.
Still, on balance, he thinks that Freddie’s CES proposal is on mission for the agency while creating opportunities for homeowners and investors alike.
“I think there’s a great argument to be made that the GSEs are supposed to be providing financing in this environment, where first liens are low, locking in relatively low mortgage volume, and maybe hampering access to tapping home equity for underlying GSE borrowers,” Hunsaker said.
Ryan Craft is CEO of Saluda Grade, a real estate advisory and asset management firm that has been a key player in helping to expand CES securitization in the PLS market in the past few years. He said it’s difficult to assess the impact of Freddie’s plan to begin purchasing CES loans because the final details of that effort are still under review and subject to public feedback.
Still, he said, there is some concern that providing easier access to second-lien mortgages could “permanently impair prepayment speeds” for bonds already issued against the first-lien mortgages. This so-called extension risk means bond investors have to wait longer to receive payments from the underlying loans, which in turn could lower the trading value of the bonds.
Craft, however, points out that this also is a risk that would develop potentially if all CES securitization went through the private-label market. He believes much of that risk is already “relatively priced into” the market.
“It would not be surprising to anybody if they [Freddie] launched this [CES plan], that it would be competitively priced, and it would be successful in originating a significant amount of volume,” Craft added.
“…There’s a lot of questions to be answered on how much it is actually going to take away from the private-label market. But I do believe that what is going to outweigh that [concern] is that it’s going to further put into the mind of American homeowners that you can use second-lien or home equity debt to be able to tap into your greatest asset. So, I think more so it’s going to grow the total addressable market rather than reduce the availability [of CES] for the private-label market. … I would love to piggyback on their [the GSE’s] marketing budget.”
Non-QM concerns
Craft also took issue with the concern that if Freddie enters the CES market, it would somehow steer riskier credits toward the private-label market.
“I think mortgage risk can be competently priced … and underwritten,” he explained. “So, to say that the non-QM [nonagency] version of second liens will inherently be more risky, I think any non-QM investor would disagree.”
Non-QM loans include those that cannot command an agency stamp through Fannie Mae or Freddie Mac — including jumbo loans. The pool of non-QM borrowers includes real estate investors, fix-and-flippers, foreign nationals, business owners, gig economy workers and the self-employed.
The Intercontinental Exchange (ICE) Mortgage Monitor estimates that there is a total of $11 trillion in tappable home equity available nationwide (what’s left after accounting for a 20% equity cushion for homeowners), with two-thirds of the total held by homeowners with first-lien mortgages below 4%.
In addition, five West Coast markets — Los Angeles, San Francisco, San Jose, San Diego and Seattle — account for nearly one-quarter of the tappable equity. Jumbo loans are common in these metro areas.
Craft said that it’s hard to “come up with some big loser” if either of the GSEs move into the CES space.
“I think that that’s probably ironic, because the perception would be that Saluda Grade is one of those entities that would be negatively impacted,” he said. “In fact, it would be unusual to be against more liquidity coming into the home equity market.”
