Freddie Mac’s Second Mortgage Pilot: Should the Taxpayer Subsidize Equity Extraction Lending?

Introduction

In April, the Federal Housing Finance Agency (FHFA) officially solicited public comment on a proposal from Freddie Mac, one of the two large government-sponsored enterprises (GSEs) it oversees, to begin a pilot program to finance closed-end second (CES) mortgages.¹ The Proposal, which was approved by the FHFA in June with several important restrictions,² was driven by a change in interest rates that has made cash-out refinancing (refi) economically expensive for homeowners. The pilot program aimed to provide an alternative to cash-out refi for homeowners to extract equity from their homes. While some argue that the pilot program aligns with the mission of the GSEs, others believe it deviates from their intended purpose of promoting homeownership. This article analyzes the arguments for and against the pilot, addressing in some detail specific points related to credit risk, mission alignment, and the adequacy of the private market.

As background, the specific genesis of Freddie Mac’s proposal (the Proposal) is that the U.S. went from having unusually low interest rates to much higher rates very quickly. Thus, if homeowners want to extract cash from some of the equity in their home by doing a cash-out refi, a product long offered by the two GSEs, it is financially quite expensive. That’s because the existing mortgage, at very low rates for so many borrowers, would have to be given up to obtain the extra cash, as the entire new mortgage would be at today’s high rates. By contrast, extracting equity via a CES mortgage at today’s rates still allows the existing, low-rate first mortgage to stay in place.³

According to the logic of the Freddie Mac proposal, since the company was already allowed to offer a cash-out refi, it should also be allowed to offer a CES mortgage. This is because both mortgage products perform the same underlying economic function of providing cash to the homeowner by extracting equity, with the CES mortgage doing so in a way that better aligns with today’s interest rate environment. Thus, one view of this pilot is that it is of little policy consequence, as the CES mortgage offering, with the specific requirements and constraints described in the proposal for the pilot, is indeed just a near-alternative to the standard cash-out refi long done by the GSEs.

However, the proposed pilot also raises a very different and long overdue policy question: whether it makes sense for the GSEs to offer any type of equity extraction lending at all, cash- out refi included. Simply put, equity extraction lending is far from the GSEs’ mission, which is often summarized as “to help homeownership.”⁴ Since the CES mortgage borrower in the pilot would already own their own home, already have a taxpayer-subsidized first mortgage,⁵ and also have considerable equity in the home, how would making an additional taxpayer- subsidized loan to extract equity help homeownership? It seems clear it would not.⁶

From this perspective, the pilot is arguably a significant move by the GSEs to informally expand their mission beyond housing or homeownership by providing taxpayer-subsidized loans that can be used for purposes other than housing-related ones.⁷ In fact, the CES mortgage’s only required nexus to housing at all is that built-up homeowner’s equity is used, via a second mortgage, as collateral for the loan. Given the amazing run-up in house prices since the beginning of the pandemic,⁸ homeowners equity has rapidly climbed to an all-time high – almost $33 trillion.⁹ This could result in the GSEs becoming a major general consumer lender, unmoored from their housing mission except by being limited to the amount of home equity that can collateralize a second mortgage.

To examine the pilot and these two contrasting viewpoints, this article will first review the facts surrounding key arguments both in favor and also against the Proposal made by commenters.¹⁰ It will then discuss in depth three of those arguments in order to fully understand the implications of a GSE offering to purchase CES mortgages. 

The conclusion of the analysis is that the GSEs should not offer CES mortgages since doing so falls outside the companies’ housing mission and thus should not be offered to homeowners with its taxpayer-subsidized low cost. In addition, the available evidence suggests that the private sector is adequately providing both home equity lines of credit (HELOCs) and CES mortgages already, both of which allow homeowners to extract equity without needing to pay off their inexpensive first mortgage. This means the subsidized GSEs entering the market would create unfair competition against the private sector. Together, these two reasons provide strong support to the argument that it was unwise for the FHFA to approve the pilot.

The article will conclude by looking beyond the just-approved Freddie Mac pilot to address the broader question: Should any equity extraction products at all, including cash-out refi, be supported by a GSE? If the FHFA is to keep the GSEs focused solely on true mission activities, the answer would be no.

The arguments pro and con

Freddie Mac’s CES mortgage proposal generated a significant number of comments from many groups and individuals, including think tanks and elected officials across the political spectrum, and also many housing-related industry associations. The comments varied widely, with some being highly supportive and others highly opposed, leading to no consensus on the Proposal.

Supporters of the pilot, which in particular included left-leaning think tanks and elected officials, plus certain industry associations, made three key arguments in favor of the FHFA approving it:

• It is almost equivalent to the cash-out refi mortgage loan long purchased by the GSEs. This is, of course, correct.
• The uses of the cash obtained will be socially worthy. Supporters cite sympathetic uses, such as making necessary home repairs, paying unexpected medical bills, helping financially stretched working-class families, paying a child’s college tuition, etc. However, the Freddie Mac proposal has no restrictions on what the funds can be used for, so this is just a supposition, and the funds could just as well be used for things like ocean cruises, purchasing a luxury car, and so on. Also, supporters fail to clarify why even their cited examples justify a taxpayer subsidy,¹¹ which is inherent in GSE loan purchases, rather than borrowers just accessing the private market that already offers multiple types of equity extraction loans.
• The private market is somehow defective or inadequate in its offering of CES mortgages, and so the GSEs must help fill the gap. It is very much a judgment call to determine when a market is somehow defective or inadequate, but the data available support the conclusion that the private market does provide reasonable access to multiple equity extraction lending products, as further discussed below. Supporters also do not address how the GSEs, which can underprice private market CES mortgages by utilizing their taxpayer subsidies, could act to primarily expand the CES mortgage market – which is the underlying policy objective of the Proposal – rather than to instead mainly shift market share to themselves and away from existing private market competitors.

Opponents of the pilot, which in particular included right-leaning think tanks and elected officials, plus certain other industry associations, have also made three key arguments for the FHFA to deny the pilot:

• CES mortgages represent a high-risk loan by the GSEs and would cause large losses in an economic downturn. The pilot is actually specifically designed to ensure that this is not true; in fact, its design will result in the credit risk being well within the risk appetite that the GSEs have long had during conservatorship. This is examined below in more detail.
• The private market for CES mortgages and related equity extraction products is fully adequate and does not need government entry to improve it. This is the flip side of the viewpoint cited above, which is further discussed below.
• The Freddie Mac CES mortgage product does not align with the housing mission of the GSEs. An analysis of this argument presented below confirms that it, indeed, does not appear to fit with their housing mission.

This article will now delve more deeply into the three topics indicated above for further discussion and analysis: (1) assessing the level of credit risk to Freddie Mac; (2) evaluating whether offering CES mortgages aligns with the mission of the GSEs; and (3) examining how well the private market already supplies equity extraction lending products.

Risk: The credit risk to the GSEs of offering CES mortgages is well within their existing risk appetite

Freddie Mac’s proposal is to purchase fixed-rate CES mortgages with an amortizing 20-year maturity. Its terms are specifically designed to align the credit risk of the CES mortgage with the risk already routinely accepted by Freddie Mac when it does a cash-out refi. So, for example, Freddie Mac must also own the underlying first mortgage, and if the first is paid off the second must be as well. This puts Freddie Mac in virtually the same credit risk position as if it owned a first mortgage on the entire first-plus-second mortgage amount, i.e., just as if a cash-out refi had been done.

In addition, Freddie Mac has long been conservative in its credit risk appetite for a cash-out refi, reflecting its questionable mission value, a topic analyzed below. This is evident in its decision to limit the maximum loan-to-value (LTV) ratio to just 80 percent. This credit policy will also apply in the pilot to the combined value of the first and CES mortgage, meaning that its 80 percent maximum LTV is actually more restrictive than what otherwise applies to the majority of GSE purchase loan originations, which can range up to 97 percent LTV in certain cases.

That means the pilot is very credibly a safe and sound credit risk undertaking, fitting well within the long-established risk appetite of the GSEs since they have been in conservatorship.¹²

Mission: Equity extraction products do not fit within a reasonable definition of the GSEs’ homeownership mission

All GSEs are hybrids created by Congress. On the one hand, they are designed to be for-profit companies owned and capitalized by private market shareholders seeking a normal market return. On the other hand, they are required to undertake a public policy mission that does not generate such a return, leading to Congress also awarding them subsidies to ideally even it all out.¹³ Unfortunately, Congress did not explicitly define the GSEs’ mission in the legislation creating Freddie Mac or Fannie Mae, leaving it instead to be defined indirectly by their legislatively permitted activities and more general language. As a result, determining their mission is somewhat subjective.¹⁴

We do know, however, that the FHFA recently reviewed and then categorized the various products offered by the GSEs based on their level of mission intensity, with guarantee fee pricing being set lower on the most mission-intense and higher on the least. The latter, sometimes called “mission-remote” products, consists of mortgages on second homes (i.e., not the primary residence of an owner-occupier), investor property mortgages, certain large balance mortgages and, of particular importance to this article, cash-out refis. Leaving aside large balance mortgages, which arise from a requirement set by Congress, it is probably a surprise to many readers that the GSEs even offer second home or investor property mortgages. This is because the GSEs’ mission and the subsidies awarded to them are commonly understood to be aimed only at owner-occupied, primary residence housing. As a result, the FHFA has priced higher guarantee fees on these two products. But at least these two products are fully related to housing.

By contrast, as already described above, equity extraction through CES mortgages can be very little related to housing. The only required nexus is that homeowners’ equity is used as collateral via a second mortgage. Otherwise, the funds can be used for any purpose. Ditto for the cash extracted via cash-out refis.

Homeownership is, of course, a core part of the American Dream. In my experience, the most cited reason why is that it has historically proven to be the method for the typical middle- or working-class homeowning family to successfully build net worth. Many supporters of the GSEs mention how this helps such families be more financially secure, have a better retirement and be able to pass more wealth onto the next generation.¹⁵ Also frequently cited is family stability, i.e., not being subject to landlord actions that might require unwanted relocation. This reasoning helps to explain the policy justification for the government’s massive intervention in and subsidization of the market for first mortgages. Although that justification appears nowhere in the legislation creating the GSEs, it is quite broadly accepted by a wide range of policymakers.

However, equity extraction works against the buildup of equity, reducing it anywhere from a little to a lot. Of course, that does not mean that homeowners should be barred from extracting some of their home equity as they deem appropriate, but it does mean that there is no obvious justification why it should be subsidized by the taxpayer.¹⁶

In fact, considering that the FHFA has already increased the guarantee fee on cash-out refis because it is so poorly tied to the GSEs’ mission, supporters advocating for the GSEs to enter the CES mortgage market with the justification that it falls within their core mission is wholly inconsistent.

Private markets: They do not have a material defect or inadequacy that warrants subsidized (“unfair”) competition by the GSEs

Until the recent run-up in interest rates, the most common ways for homeowners to obtain cash by extracting equity were via HELOCs and cash-out refis.¹⁷ The former, in particular, fits the balance sheet and business model of banks and other depositories, while the latter has been funded largely through the government mortgage agencies (i.e., the two GSEs plus three others). The CES mortgage product was simply not in much demand given the rate environment.

With today’s much-changed rate environment, the demand for the CES mortgage is rapidly growing, and the private market provision of the product has grown along with it. One comment letter submitted to the FHFA¹⁸ cited the following about the size and high growth rate of CES mortgages that are securitized into the capital markets:

“According to data compiled by Equifax, $53 billion in closed-end seconds were originated between January and August 2022, which was a 50 percent increase from 2021…The origination market is supported by a residential mortgage-backed securitization market for closed-end second loans and HELOCs that totaled $4.5 billion in 2023 and is on pace to be an $11 billion market in 2024.”

In addition, CES mortgage products are being offered by many depository financial institutions, but definitely not universally. For example, in terms of credit unions – which tend to focus on low- and middle-income households – two of the five largest offer CES mortgages with a variety of maturities (e.g., Navy Federal, the largest with 13 million members, offers 5, 10, 15 and 20- year maturities). In terms of commercial banks, which vary significantly between being consumer-focused, business-focused, and even just online, I analyzed those ranked #11 to #20 by assets as an initial proxy for those which are more local and consumer-oriented. I then omitted the three online-only banks amongst those ten, which leaves seven branch-based banks. Of those seven, three offer CES mortgages, while four do not.

Additionally, HELOCs are offered by almost every bank and credit union in the country. HELOCs are a very popular financial product that provides the homeowner tremendous flexibility to borrow specific amounts at multiple points in time, allowing repayments over long and short time periods. Importantly, a HELOC preserves the existing first mortgage, similar to Freddie Mac pilot’s CES mortgage. With outstanding HELOC balances surpassing $350 billion, it is evident that this mortgage product has been highly successful.

As mentioned earlier, categorizing any market as either adequate or somehow deficient is a judgment call. But the above-cited evidence strongly suggests that the private market for equity extraction products – considering both the large HELOC market and the rapidly growing smaller CES mortgage market – is not in some manner defective or inadequate.

However, some supporters of the pilot compare the CES mortgage private market to the first mortgage market, which is extraordinary in how it has low-cost pricing, generous credit availability, and borrower-friendly features that are all standardized nationwide. It’s important to note these attractive features do not reflect a normal, competitive private market but instead are the product of massive federal government intervention to the point where the five government mortgage agencies today account for just over 70 percent of the near-$13 trillion of first mortgages outstanding nationwide. So, if the first mortgage market is the standard against which to judge whether a private market is adequate or has a defect, then no private sector market will ever pass muster. Thus, a comparison to the first mortgage market definitely seems to me to be inappropriate.

(Unusually, there is some evidence that the FHFA, via the pilot, is looking to determine if there is a market defect or inadequacy not broadly but on a highly targeted basis, specifically looking at underbanked communities, including rural areas, that tend to have populations with lower incomes. Such a narrowly targeted product proposal is unconventional, and so comments submitted by the public to the FHFA on the Proposal did not focus on such a possibility. If the FHFA, at the end of the pilot period, finds such a narrowly defined market weakness and thus decides to enter the market permanently on an equally narrowly targeted basis, it will face a host of issues: how to price the guarantee fee up enough to negate the subsidy inherent to GSE funding, how to keep the product targeted geographically without it bleeding into broader markets, etc. This paper does not address those issues, as it is too speculative at this point.)

Conclusion: The long-overdue policy question

As mentioned above, the CES pilot proposal and its quick approval have put a spotlight on the policy question: What types of mortgage financing should fall within the mission of the GSEs, and are thus deserving of being taxpayer-subsidized, versus those that are not? The analysis herein concludes that equity extraction lending is simply not within their mission. Therefore, in my view, the CES mortgage pilot should be allowed to lapse, and the matter concluded.

The analysis above also suggests that the GSEs have arguably and unfortunately already gone beyond their mission in offering cash-out refi (since it represents the same type of equity extraction lending) as well as by purchasing mortgages on second homes and investor properties (since it goes beyond funding owner-occupied principal residences). Ending such long-offered products is, of course, more difficult – especially politically – than just letting the CES mortgage pilot end. It is, however, better public policy to discontinue these activities in a well-orchestrated manner designed to minimize market disruption, rather than the alternative of keeping them for the long term to serve as a visible example of taxpayer subsidies being unwisely used by the GSEs.

 

Footnotes

¹ See the Federal Register, April 22, 2024, “Freddie Mac Proposed Purchase of Single-Family Closed-End Second Mortgages; Comment Request.” https://www.federalregister.gov/documents/2024/04/22/2024-08479/freddie-mac-proposed-purchase-of-single-family-closed-end-second-mortgages-comment-request. Note that it refers to the specific type of second mortgage being proposed as a “closed-end second,” i.e., loans secured by a second mortgage and which are fully-funded, where the loan amount is borrowed upfront and paid down over time. This serves to distinguish it from the more common home equity line of credit (HELOC), which is also secured by a second mortgage but which has principal outstanding that can go up and down over time

² The most important restrictions: a limit on the amount of $2.5 billion over an 18-month period of the pilot, a limit on the individual borrowing amount of $78,277, and just one product offering of 20-year maturity. It is unclear if any or all of the latter restrictions are meant to be permanent, or just apply temporarily during the pilot.

³ It should be noted that the common HELOC also supports equity extraction while leaving the existing first mortgage in place, and on very flexible terms with no fees upfront. There was surprisingly little mention of this by the FHFA or most commentators. It will be included in the discussion below at certain key points.

⁴ This is related to the single-family activities of the GSEs. They also have a smaller line of business providing financing to apartment landlords, where the focus is obviously not on homeownership but instead helping rental housing be more affordable over time via its subsidized financing.

⁵ A requirement of the Freddie Mac proposal is that the borrower already have a Freddie Mac-owned first mortgage.

⁶ The one exception would be if the proceeds were to be invested in home repairs or renovation. However, there is no such restriction by the terms of the pilot.

⁷ The GSEs have obviously already taken one step in this direction by offering cash-out refis. This issue is discussed more fully below.

⁸ According to the FHFA house price index, from 2020 Q1 to 2024 Q1, house prices (seasonally adjusted) have increased by 49 percent.

⁹ See Urban Institute “Housing Finance At A Glance,” June 2024, page 6. https://www.urban.org/sites/default/2024-06/Housing-Finance-At-A-Glance-Monthly-Chartbook-June-2024.pdf.

¹⁰ For all 443 responses submitted by the public to the FHFA’s request for comment, see: https://www.fhfa.gov/regulation/federal-register/notice/2024-n-5.

¹¹ A related issue is whether the CES mortgage borrowers will skew wealthier than most households. One elected Democratic member of Congress (Ritchie Torres, D-NY15), submitted a comment on the Proposal to the FHFA that specifically cited such a skew as a reason to argue against the pilot being approved.

¹² There is a second risk related to the GSEs purchasing mortgages: hedging the market value of mortgage loans from when they are purchased by a GSE to when they are securitized. For first mortgages, in most cases this happens simultaneously, with only a minority of the flow requiring hedging. As the agency MBS market is so large, instruments to do this are readily available and reasonably effective. For CES mortgages, at least to start, none will happen simultaneously and the instruments available to do the hedging will be more limited with less effectiveness. So, per dollar of originated loan, CES mortgages will have a higher hedging risk than do first mortgages. However, the size of hedging risk is small versus the credit risk being taken, so this does not change the conclusion that CES mortgages, as proposed in the pilot, fall well within the long-time risk appetite of the GSEs.

¹³ See my previous article that discusses this in more depth. https://www.furmancenter.org/thestoop/entry/the-gse-public-private-hybrid-model-flunks-again-this-time-its-the-federal-home-loan-bank-system-part-1.

¹⁴ Interestingly, the FHFA – in its review of the Federal Home Loan Bank System (together considered the “third GSE”) now underway – is engaged in soliciting public comment on what the mission should be as part of a rulemaking to make it clearly defined. This suggests that Freddie Mac and Fannie Mae should have a similar exercise before they exit conservatorship.

¹⁵ This passing of wealth to the next generation is frequently cited as taking the form of helping pay for college for children or grandchildren, or helping a child buy a first home.

¹⁶ In addition, there is considerable policy commentary about how the typical family’s retirement savings are inadequate. Thus, it would also clearly be bad retirement policy to encourage home equity extraction borrowing by subsidizing it.

¹⁷ As previously noted, much of the commentary about the Proposal compares CES mortgages solely to cash-out refi, ignoring HELOCs. In my view, that is insufficient in trying to analyze the “private market.”

¹⁸ See the submission by the Housing Policy Council, https://www.fhfa.gov/sites/default/rulemaking_comments/fhfa_1610/Attachments/16474/HPC%20Letter%20to%20FHFA%20on%20Freddie%20Mac’s%20single-family%20closed%20end%20second%20mortgage%20proposal_final.pdf, in particular the “Question #3 Response.”