Original posted on the Housing Wire by Diana Golobay:
Second liens, commonly made in the form of home equity lines of credit (HELOCs), are so far a silent hazard to first lien bond holders in residential mortgage-backed securities (RMBS), as many of these investors may not even know if a second lien is tied to their collateral investment.
And as the press continues to focus on subprime fall-out, strategic default and option ARM resets, experts warn that these “silent second” HELOCs may become a much louder problem, according to converging data from a consumer credit agency and securities research team.
They say that investor claims on the underlying assets are potentially compromised by federally-subsidized modifications of first liens. In the short term, investors of RMBS may see reduced cash flow as the borrower’s second lien debt is piled onto the underwater property, further constricting household finance. Along a longer timeline, the risk of default rises as negative equity increases.
HELOCs were common in 2002 in cases where homeowners put 20% or 25% down, according to HousingWire sources. Homeowners often opened home lines of credit to access the equity in their homes – even as early as the closing table. Getting closer to 2007, less and less money was being put down on homes, though the rate of HELOC origination did not necessarily slow.
Once house prices began to fall, the presence of second liens became a major issue to first lien holders. Not only were borrowers increasingly trapped in negative equity positions on first liens, but additional debt from second liens placed all the more financial pressure on performance. Additionally, some RMBS analysts say first lien holders also lacked clarity regarding which first lien assets are also secured by second liens. First lien RMBS investors were not automatically notified when second liens were made on the underlying property.
Amherst Securities Group back in March 2009 warned the administration’s Home Affordable Modification Program (HAMP) would be detrimental first lien holders in private-label RMBS.
Holders of second liens are not forced to participate in HAMP, and “acute” conflicts of interest arise between servicers and investors, especially when the servicer of the first lien also services the second lien. HAMP also “violates the time-honored” cash flow priority where second liens are written off before cash flow on the first lien suffers, Amherst said.
The plan for federal modifications “in combination with the servicer safe harbor [that protects servicers from legal backlash for complying with the Truth in Lending Act], leaves the current first lien holders with no protection,” said Laurie Goodman and Roger Ashworth from the Amherst team. “It is the equivalent of having the fox guard the hen house, with the fox in possession of the only set of keys.”
Goodman and Ashworth added: “And it potentially corrupts the integrity of the securitization market. In any structured security, the prioritization of claims is integral to valuation. Once the precedent is set to violate this hierarchy, by making the first liens holders incur losses without touching the second lien cash flows, the integrity is breached.”
Nearly a year later in January 2010, the Amherst MBS strategy group was still warning of the prevalence of second liens by product type (illustrated below) – which will become a much louder issue if federal modifications begin to focus on principal reduction.
“Lien priority dictates that the first mortgage cannot be written down until the second is extinguished,” Amherst said. “And second liens are not an inconsequential factor; they appear disproportionately on the books of the largest banks, so extinguishment would impact the capital position of these institutions.”
The Amherst team used the First American CoreLogic LoanPerformance Securities and and LoanPerformance TrueLTV databases to determine that more than 50% of first liens in private-label securitzations have second or higher liens behind them. The presence of this second lien raises the combined loan to value (CLTV) by more than 20 points and takes a “significant adverse impact” on the performance of first liens.
Amherst also found simultaneous second liens are more prevalent for 2006-2007 vintages, while subsequent seconds were more common within earlier vintages from 2002-2005. Default frequency is worse on simultaneous seconds than on subsequent seconds.
And as defaults rise overall in RMBS, borrowers’ use of revolving credit has also increased.
Consumer credit bureau Equifax adds that not only are CLTV ratios on current loans not widely understood, but the entire issue is under-reported in the press, in a report provided to HousingWire. In that report, 25% of borrowers with current Alt-A loans had closed-end seconds in July 2009, up from just 10% in July 2005. Equifax also indicated 23% of prime borrowers getting high use (80%) of revolving credit lines in July 2009, from 17% four years earlier. Similarly, 22% of Alt-A borrowers now have high use of revolving lines, compared with 10% in July 2005. 20% of subprime borrowers are now getting high use out of their revolving credit, compared with 10% in July 2005.