Historically, the second-lien mortgage market has been primarily prevalent in the U.S. According to the Federal Reserve Bank of New York, U.S. second-lien lending peaked in 2006 with more than 40% of mortgages including second-lien loans. However, this market took a hit globally after the financial crisis, and some lenders, like Northern Rock in the U.K., that were traditionally active in the second-lien segment collapsed and have been somewhat replaced by some new players, leading to a slow recovery of the second-lien loan volumes since the financial crisis in 2008. While the U.S. second-lien market became more popular again, it remained a niche market in the rated U.K. RMBS space.

Although the overall expected amount of over £1 billion of second-lien loans issuance in 2021 (MortgageSolution) represents only 0.3% of the U.K. gross mortgage lending over the past 12 months (as of second-quarter 2021), the market is solidifying. Six U.K. second-lien transactions have come to the market since 2018, totaling £730 million in current collateral balance, up from none in the years following the financial crisis. This U.K. second-lien mortgage market primer provides an overview of the fundamentals, key features, and current market developments, while drawing on the loan level data of S&P-rated transactions.

U.K. Second-Lien Mortgages Today

A second-lien mortgage is a credit taken against a property that is already financed with a first-lien loan with a different originator. Historically, the amount available for a second-lien loan could exceed the difference between the property value and the remaining outstanding first-lien loan taken against it. For example, a borrower with a property worth £500,000 and a £325,000 first-lien mortgage pledged against it could apply for a £175,000 (or more) second-lien loan. This understanding prevails today. Nonetheless, lenders often limit the amount available for a second-lien loan to the property's outstanding value, i.e., to a 100% aggregate current loan-to-value (CLTV) ratio, although the average CLTV is about 65% (based on the universe of U.K. second-lien RMBS transactions rated by S&P Global Ratings).

In the second-lien space, the two most common types of loans are home equity loans (HEL) and home equity lines of credit (HELOC).

Table 1

The variety of purposes required for a second-lien loan may be broader compared with the first-lien mortgage terms, enabling borrowers to be more flexible with their personal financial planning. Based on our rated universe, almost half of these loans are for debt consolidation, slightly over a quarter are for refinancing mortgages or purchasing additional properties/renovation work, and the remainder include activities such as paying tuition fees (see chart 1).

Chart 1

Some loan purposes also have a social dimension, such as debt consolidation (refinancing of debt at a lower rate) or resorting to a second-lien loan if a further advance is not allowed or acceptable to the current first-lien lender.

Second-charge loss severities tend to be higher than for first-lien pools

The term second-lien signals that the second-charge mortgage lender's claims are subordinated to those of the first-lien mortgage lender if the borrower defaults. Therefore, the higher the loan's original loan-to-value (LTV) or current LTV ratio, the lower the likelihood the second-lien lender will be fully repaid if the borrower defaults. A loss may occur, although it will depend on the associated foreclosure costs (in turn dependent on the foreclosure period and inherent interest rates on the first-lien and second-lien loans) and the recovery value, among other factors. Because of these inherent risks, the interest rates charged for second-lien loans are significantly higher compared to those on first-lien mortgages.

In the example shown in chart 2 below, a first-charge loan of £325,000 on a property worth £500,000 defaults and the property sells for £300,000 upon foreclosure (repossession value 1). The loss severity is the loss of £25,000 (£300,000 minus £325,000) divided by the loan amount of £325,000, or 7.7%. If a borrower has the same first charge-loan of £325,000 on the same property, a second-lien loan of £75,000, and the property sells for £325,000 (repossession value 2; up by £25,000 compared to repossession value 1), the first-lien holder wouldn't suffer a loss as the house would sell for the same balance as the loan. However, the second-lien holder would lose £75,000 (£325,000 minus £325,000 minus £75,000) on the sale, which, divided by the second-charge loan amount (£75,000) would be 100%.

Chart 2

As shown above, leverage matters. This risk of default/loss may be augmented if the first-lien lender grants further advances to the borrower without approval from the second-lien lender (dilution risk). An advance would further subordinate the second-lien lender's position and increase the overall LTV and, in turn, the borrower's default risk and loss severity for the second-lien lender.

The benefits of second-lien loans for borrowers

Although second-lien borrowing may seem illogical given its higher costs compared to first-lien loans, there are benefits for the borrowers.

Table 2

Second-charge mortgages often have low to no early repayment fees (unlike first-lien loans), and size-wise, they are more in line with personal loans. Additionally, the cost of borrowing is relatively lower when compared to other types of personal loans: according to the Bank of England, the U.K. credit card annual interest rate was 21.5% on average in third-quarter 2021, compared with an average interest rate of about 6.0% on S&P Global Ratings-rated second-lien loans (see chart 3). Therefore, the borrower benefits from using second-lien loans for debt consolidation, for example.

The chart 3 below illustrates how the total interest payments for the borrower vary, depending on the financing structure. If the borrower decides to use a £5,000 first-lien loan and a £5,000 credit card loan, the interest payment would be about £96 per month. On the other hand, if the borrower uses a £5,000 first-lien loan and a £5,000 second-lien loan, the monthly interest payment would be about £33, or 65% lower. The different financing structures can therefore directly affect a borrower's liquidity, with large differences in the monthly repayments due to the difference in interest rate on each type of loan.

Chart 3a

Chart 3b

Lenders' assessment of potential borrowers' creditworthiness

As mentioned above, the second-lien mortgage lending characteristics today are different from those originated before 2008 (see table 3). The regulations under the Mortgage Conduct of Business (MCOB) support current underwriting standards. There is now a strong emphasis on borrowers' creditworthiness, unlike in 2008 and before.

Table 3

Most of today's second-lien lenders follow a scoring-based methodology from established and specialized U.K. based institutions i.e., Equifax or TransUnion, providing second-lien loans only to borrowers above a pre-determined score. This approach provides more certainty to the lender and enables them to adjust the underwriting standards to their own risk tolerance. According to this assessment, lenders are then also able to adjust their charged interest rate for the loan.

After the lender has pre-scanned the potential borrower's credit score, only those who pass the pre-defined threshold are assessed by lender-specific rules (i.e., age, history, employment status, etc.). Some lenders might also use an additional framework and create a scorecard to determine which plan the borrower is eligible for. An additional examination of the borrower's overall situation is then based on factors such as location, security ranking, and LTV, among other factors. The score of this assessment then drives the pricing.

Although the decision tree tends to be broadly similar, not all second-lien lenders are equal. One major difference is their lending strategy, i.e. their risk approach and the charged interest rate. While it may vary slightly across individual queries/borrowers, the overall tendency of the providers on the market may be classified from aggressive to more conservative lending practices (see chart 4).

Chart 4

FCA Guidance And Protection Of Third-Party Interests

Second-lien lending has become more transparent and gained in credibility since 2016 as it is now subject to the same MCOB and regulations as those for first-charge mortgages. For instance, the loans are tested for affordability--the Bank of England base rate is stressed over five years by 3%. In addition, a borrowers' non-mortgage-related households' expenditures are assessed as well (see "The U.K. Residential Mortgage Market’s Resilience Could Withstand Brexit Pressures," published on April 15, 2019).

Following the Financial Conduct Authority's (FCA) guidance, the "Responsible lending and responsible financing of home purchase plans" (MCOB 11) presents a framework to the lender, assuring that second-lien loans are only put in place with customers who are capable and creditworthy enough to repay all of their other liabilities and obligations as well as their second-lien loans. If a customer misses a payment or is unable to pay, the "Arrears, payment shortfalls and repossessions: regulated mortgage contracts and home purchase plans" (MCOB 13) lays out steps to follow before any possession action is necessary. In addition, the "Charges" section in MCOB 12 and "Disclosure at start of contract and after sale" (MCOB 7) present the rules for charges and post-sale disclosure, respectively.

As observed throughout the financial crisis in 2008/2009, overleveraged borrowers could lead to increased delinquency and default rates throughout an economic crisis, especially when combined with rising unemployment. The FCA guidance is meant to address this, in our view.

As mentioned above, the U.K. second-charge loan is regulated under the MCOB following the same principles and procedures as its first-charge counterpart. Within this legal framework, second-lien lenders are treated subordinated in the foreclosure process if a borrower defaults. As the pay-out follows a sequential logic, the first-lien lender is fully paid off before the second-lien lender receives any payment.

However, second-lien lenders can take additional steps to protect their claim, but they are not obligated to do so. As a first-lien lender has a precedence claim on the property over the second-lien lender, the latter can apply for a notice or a restriction to improve its position in case of foreclosure (see chart 5). Each method has different techniques linked to certain benefits and drawbacks for the lenders, and could vary depending on the lending circumstances.

Chart 5

A notice is a legal statement of interest in the property that has legal precedence over other claims coming later. It can be agreed or unilateral. According to section 34(2)(a) of the Land Registration Act 2002, an agreed notice is a document where the proprietor acknowledges the lender's claim, while a unilateral notice is only signed by the second-lien lender who would then be interested in purchasing the property. Although it strengthens the second-lien lender, a notice is not a guarantee of the lender's interest being fulfilled. It will only ensure that the lender's interests are not overlooked, and that the priority is in place.

According to rule 80 of the Land Registration Rules 2003, there are some cases where the lender would need to apply for an agreed notice. While some instances require an agreed notice, a unilateral notice is faster to put in place (as fast as 24 hours).

There are also certain situations where a notice cannot be used, and a restriction is necessary. It can support the lender in various ways: the lender can restrict the borrower from selling the property without their approval, it can put covenants in place for the borrower, or prohibit the sale in general. The restriction can be absolute or dependent on certain events, such as the consent of the lender or different third-parties. The restriction is not guarantee that the lender will be able to redeem its entire claim, but it can reduce the loss risk. Since this procedure is more complex, it also takes longer to be put in place.

The U.K. Second-Lien Securitization Market

A second-lien loan is in effect the first-loss piece (i.e., the second-lien loans are hit first before any losses are incurred by the first-charge holder). To the extent risk is priced correctly, the higher interest rate charged on second-lien loans compared to first-lien loans is a positive for RMBS transactions as it contributes to higher excess spread.

Unlike in the period leading up to the great financial crisis, the market has recently witnessed pure second-lien transactions whose collateral comprises only second-lien loans, instead of legacy nonconforming transactions with a small proportion of second-lien loans. In our view, this is in part because the overall availability of second-lien loans has increased significantly due to the low interest rate environment and to the presence of a greater number of 'specialist lenders' active in this market segment (unlike before the financial crisis where second-lien loans only accounted for a small part of lenders' broad product range). In addition, house price growth over the past few years has helped build equity levels conducive to greater second-lien loan issuance, in turn benefitting the U.K. RMBS market with a more active primary market. Secondly, second-lien loans are perceived as less risky today than they were 15 years ago, partly due to their falling under the FCA's regulatory umbrella since March 2016.

Table 4

Notably, the recent issuance has been dominated by only a handful of issuers as shown on table 3 above--Optimum Credit Ltd. (Castell 2020-1 PLC and Castell 2019-1 PLC), Together Financial Services Ltd. (Together Asset-Backed Securitisation 2020-1 PLC and Together Asset-Backed Securitisation 2021-1 CRE2 PLC), West One Secured Loans Ltd. (WOSL; Elstree Funding No. 1 PLC and Elstree Funding No. 2 PLC), and Oplo Group Ltd. (Polo Funding 2021-1 PLC)--while a couple of large second-lien players such as United Trust Bank and Step One Finance Ltd. have not yet tapped the primary market. Also, the transaction size tends to be on the low side, below £250 million. Finally, legacy transactions are mixed pools and are only marginally exposed to second-lien loans.

Credit performance has been strong

Within the S&P Global Ratings-rated second-lien mortgage universe, credit performance is stable compared with our RMBS indices whether it be arrears or defaults (see table 2). Of note, securitized second-lien transactions have so far tended to be executed by the conservative end of second-lien lenders.

Another possible explanation for the lower arrears and defaults is that on average second-lien loans carry significantly higher interest rates and low or non-existent early repayment charges, which incentivize borrowers to repay their loans as early as possible to avoid a prolonged period of high regular repayments. This also leads to higher constant prepayment rates for second-lien loans compared to first-charge loans.

Our Credit Analysis Of Second-Lien Loans

Under our global RMBS criteria, we adjust our assessment of the credit quality of the underlying assets with a second-lien exposure.

The weighted-average foreclosure frequency (WAFF) measures the probability of default and represents the proportion of loans in terms of current balance in a pool that we estimate to default based on a stress level (from 'AAA' to 'B'). Compared with a first-lien loan, we adjust the foreclosure frequency of a second-lien loan by 1.3x–1.7x, depending on the purpose of the loan (i.e., 1.3x for second-lien loans not taken out to consolidate debt) and the level of information provided (we adjust by 1.7x if there is insufficient data to back up other second-lien adjustments).

The weighted-average loss severity (WALS) represents the proportion of loans in terms of current balance in a pool that we estimate to lose following foreclosure based on a stress level (from 'AAA' to 'B'). Compared with a first-lien loan, the foreclosure period for second-lien loans is longer and the foreclosure costs are higher: we assume a 21-month foreclosure period (versus 12 or 18 months for buy-to-let or owner-occupied first-lien loans, respectively, in England and Wales). We then adjust the determined WALS for higher foreclosure costs of £7,000 for a second-lien loan instead of the £5,000 fixed costs for a first-lien loan, plus 3% variable as a percentage of the post-repossession valuation.

In table 5, we show three different base cases:

• Neutral effective LTV (Base 1);
• Low effective LTV (Base 2); and
• High effective LTV (Base 3).

We test the effect of a variation in the effective LTV (by an increase in second-lien balance) and in the interest rate on the second-lien loan on the WAFF and WALS. Given the effective LTV curve, the effect of an increased debt amount via a second-lien loan is more acute (and asymmetric) at high LTVs--scenarios 1.X and 3.X show more significant increases in WAFF than scenarios 2.X. Higher debt-to-income ratios also drive the higher WAFF.

Secondly, loss severity tends to be on the high side even for small second-lien balances due to the subordination effect and denominator effect.

Eventually, the interest rate itself on the second-lien loan has only a marginal effect on the WALS. This holds true across the three different bases.

Table 5

What's Next For Second-Lien Loans?

We expect the volume of U.K. RMBS issuance backed by second-lien loans to rise given the house price growth, the origination pace, and investors' demand attracted by higher margins and strong credit performance.

Four trends are slowly emerging:

• HELOCs: These types of loans may be gathering steam as borrowers may see them as a flexible way of borrowing against the equity built in their property. This kind of product is already common in the U.S., Canada, and Australia. It's attractive due to its hybrid nature: lower interest rates than personal loans or credit cards, the interest is only charged when the line is drawn, and the loan amount could be high and for a longer maturity.
• Piggyback loans: These typically allow the borrower to plug the difference between the amount that a first-lien lender is ready to lend and the equity available (likely to be lower than that required) to the buyer to buy a property. For instance, the borrower would take an 80% LTV loan with first-lien lender A, then a piggyback loan of 10% LTV with second-lien lender B, and bring 10% of equity. The novelty here is that lenders A and B would use the same origination process.
• Private (non-interest-bearing) HTB loans: These are essentially a private version of the government-sponsored HTB scheme. The second-lien lender would replace the government's equity loan and would also charge no interest. While the HTB scheme is aimed at first-time buyers with limited equity and willing to buy newly-built properties, the private version could finance an existing or a new property and would share with the borrower the upside of the property value, in turn increasing the value of the second-lien loan at the time of repayment.
• Second-lien loans for business purposes: Due to the financial strain caused by the COVID-19 pandemic, some business owners may use second-lien loans to raise capital for business purposes, like to re-organize their office spaces.

Related Criteria

• Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019

Related Research

• The U.K. Residential Mortgage Market’s Resilience Could Withstand Brexit Pressures, April 15, 2019