A New Look at Second Liens

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Second liens were strongly associated with the use of low down payments to purchase homes.

Second lien loans are an important segment of the credit markets in the United States, even larger in the aggregate than total credit card borrowing. In A New Look at Second Liens (NBER Working Paper No. 18269), authors Donghoon Lee, Christopher Mayer, and Joseph Tracy use data from credit reports and deed records to investigate the extent to which second liens may have contributed to the recent housing crisis and subsequent foreclosure crisis.

While second liens were widely available prior to the crisis, they came in two very different flavors. Home equity lines of credit (HELOCs) were attractively priced, but originated to people with high credit scores and to home owners who either had no first lien or who had a prime first mortgage -- that is, the highest credit quality borrowers. Their originations peaked in 2004, before the peak in home prices, and defaults on them have been relatively low compared to other types of mortgages.

By contrast, closed-end second liens (CESs) often were issued to borrowers with low credit scores and were more likely to be originated at the same time as a first lien (a so-called piggy-back mortgage) or with a non-prime first mortgage. The issuance of CES mortgages peaked between 2005 and 2007 when credit standards had deteriorated and house prices were at their peak. Subsequent default rates have been very high.

Second liens helped to finance a large share of home purchases during the housing boom. At the peak of the housing market in 2006, more than 40 percent of home purchases in coastal markets and bubble locations involved a piggyback second lien. Second liens were strongly associated with the use of low down payments to purchase homes; they may have allowed some borrowers who might not otherwise have been able to purchase a home to do so. While this borrowing pattern suggests a link between second lien borrowing and the housing bubble, the authors are not able to determine with existing evidence the extent to which this relationship is causal.

In general, they find that default rates on second liens are similar to those on first liens on the same home, although HELOCs perform better than CESs because of the timing of their origination and the quality of borrowers. Borrowers with second liens are more likely to initially become delinquent on their first mortgages than on their second liens, but if that delinquency persists, they are likely to eventually default on their second lien. Nonetheless, roughly one quarter of borrowers will continue to pay their second lien for more than a year while remaining seriously delinquent on their first mortgage.

Finally, the authors show that delinquency rates on second liens, especially HELOCs, have not declined as quickly in the last few years as those for most other types of credit. This raises a potential concern for lenders with large portfolios of second liens on their balance sheets.

--Claire Brunel