Why a tsunami of liquidity might be on its way

World financial markets are addicted to liquidity to maintain the price level of assets. In a move reminiscent of the over-lending in the 2008 GFC asset bubble, Congress is voting on allowing lending on Second Mortgages by Federal Agencies in a move that could lead to a tsunami of liquidity.

Congress recently approved a pilot program that allows Freddie Mac, a government-sponsored enterprise (GSE), to purchase second mortgages. This initiative is designed to help homeowners leverage the equity in their homes more affordably, especially in a high-interest rate environment.

The Federal Housing Finance Agency (FHFA) has given conditional approval for Freddie Mac to purchase up to $2.5 billion in second mortgages over an 18-month period.  The second mortgages will be closed-end home equity loans, with a maximum loan amount of $78,277 and a minimum seasoning period of 24 months for the first mortgage.  The program aims to benefit borrowers in rural and underserved communities, providing them with a lower-cost alternative to cash-out refinancing.

The program is expected to offer more favourable terms compared to private credit markets, potentially lowering monthly payments for borrowers. With U.S. households holding approximately $32 trillion in real estate equity, the initiative could facilitate access to this capital, helping homeowners finance major expenses or home improvements.

By purchasing second mortgages, Freddie Mac aims to increase liquidity in the mortgage market, which could help stabilize the housing sector and make borrowing more accessible.

Critics argue that the program deviates from Freddie Mac’s core mission, which traditionally focuses on first mortgages and promoting homeownership. There are concerns that government-backed loans could disrupt the private lending market by offering terms that private lenders cannot match, potentially leading to higher interest rates on private-sector products. The program could shift the best credit risks to Freddie Mac, leaving private lenders with a riskier portfolio, which might necessitate higher interest rates to offset these risks.

Allowing Freddie Mac to purchase second mortgages could lead to increased homeowner leverage and significant equity extraction. This scenario mirrors the conditions that contributed to the 2008 financial crisis, raising concerns about potential financial instability.

If defaults occur, taxpayers could bear the financial burden. The potential market size for this product is substantial, estimated at $850 billion, and could double if Fannie Mae follows suit, amplifying the risk.

Some argue that this move represents a deviation from Freddie Mac’s primary mission of promoting homeownership. Instead, it appears to support existing homeowners in leveraging their equity for non-housing-related expenditures, which is inconsistent with Freddie Mac’s mandate.

The proposal could provide subsidized loans for purposes beyond home improvement, such as consumer spending, which critics argue is not aligned with Freddie Mac’s statutory goals.

There is concern that Freddie Mac’s involvement could crowd out private capital, reducing the availability of private second mortgage products and affecting the overall market dynamics

The program could lead to significant additional consumer spending by enabling homeowners to access their home equity more easily. This increased spending could exacerbate inflation, counteracting the effects of tighter monetary policy. In a US election year no less…