(Bloomberg) -- Wall Street is cranking up the bond machine as US homeowners — finding that buying a new house is out of reach since mortgage rates started climbing in 2022 – are instead getting home equity loans and sprucing up their current properties.
Roughly $18 billion of bonds, backed by consumer loans on everything from second mortgages to loans that get repaid from future home value, were issued last year, according to data compiled by Deutsche Bank AG and Bloomberg. That's triple the amount in the year prior, and sales are on pace for a similar level in 2025.
With a near-record $35 trillion tied up in US home equity, households are dipping into their housing wealth to pay for renovations and other purchases rather than buy new homes that would require them to switch into mortgages at higher rates. With sales of previously owned homes — and thus new loans — stalling, the home loan industry is paying attention.
"They're taking their mortgage-making factories and starting to use them to create home equity products," said Gabe Rivera, co-head of securitized products at PGIM.
Investment firms are scooping up the loans and then repackaging hundreds or thousands of them at a time into bonds of varying size and risk, a process known as securitization. This year, Atlanta-based Angel Oak Capital Advisors and New York's Annaly Capital Management Inc. both issued their first-ever bonds secured by home equity lines of credit. In April, mortgage servicing giant Mr. Cooper Group Inc. joined the growing ranks with its first bond backed by second mortgages.
Home equity-backed bonds are still a relatively small corner of the market, at least compared with the vast bond offerings for mortgages guaranteed by the quasi-government entities Fannie Mae, Freddie Mac and their sister organization Ginnie Mae. Together, the trio are expected to crank out some $1.15 trillion of MBS this year alone, according to Citigroup Inc. estimates.
Still, the field is growing. TPG Angelo Gordon estimates there's a $2 trillion market for home equity products. And thanks to tighter lending standards and regulations, the debt also appears safer than in the 2008 financial crisis, when many borrowers in riskier loans fell into foreclosure.
That's piqued the interest of big investors, including private credit firms, which are deploying other strategies to scale up access to home equity. One method is to agree to purchase substantially all of the loans that mortgage lenders write, even ones that haven't yet been made, as long as each fits certain criteria. Those arrangements are known as "forward flow" agreements.
Despite the growth in direct lending, the public securities markets often represent the largest and most liquid source of capital to fund such deals.
Cashing Out
To homeowners, the vast difference between the rate on their current mortgage and what they'd get with a new mortgage poses a problem. Before, when a consumer wanted to convert some home equity into cash, they could simply replace their existing mortgage with a new bigger one in a cash-out refinancing.
But with mortgage rates still high, that no longer makes sense. Instead, homeowners are using either a home equity line of credit, which is a revolving credit line akin to a credit card, or they can take out a second mortgage. Both achieve a similar purpose: convert home equity into an up-front cash advance, without jeopardizing the existing mortgage.
"Home equity products are designed to let homeowners take cash out against their house while keeping in place senior mortgages with below-market coupons," said PGIM's Rivera.
Riskier Bets
Use of a newer solution, home equity investment, or HEI, contracts more than tripled last year. They work by giving a homeowners an up front cash payment, in exchange for which borrowers agree to give lenders some of their future home equity.
HEI contracts are often used by borrowers with somewhat lower credit scores than those who borrow against their existing equity or take out second lien mortgages, and are often used to consolidate debt or pay for remodeling and home renovation projects, according to DBRS.
Some investors caution that HEI contracts resemble mortgage products with adjustable interest rates from the early 2000s, which ended up delivering losses to investors.
"Investors considering bonds backed by these contracts should carefully scrutinize them," said Michael Hislop, an analyst at Curasset Capital Management. "What kinds of borrowers are going to find HEI the most attractive? Ones without money to make mortgage payments."
DBRS said defaults of HEI contracts have been relatively rare so far, according to its 2024 report.
Stable Market
By and large, securitizations of home equity have performed relatively well in recent years.
Lending volume for home equity-related debt is far below the years leading up to the housing bubble bursting nearly two decades ago. Industry insiders say that consumer housing reforms made after the subprime housing bubble of the early 2000s have purged most of the riskier borrowers from the market and that structural housing shortages are keeping upward pressure on home prices.
Even so, there are dangers. The good performance has coincided with a period of strong housing price growth and low unemployment. If home prices were to enter a sustained decline, pressures could emerge, according to Ryan Singer, head of residential credit at Balbec Capital.
"It's true that there are trillions of dollars in home equity," said Singer. "But if you look at the individual mortgages, you can actually see that borrowers are making very small down payments on average, and that there are plenty of people with no equity in their homes."
Still, as long as interest rates remain elevated homeowners will continue to look for alternative ways to borrow. And with plenty of specialist companies tapping into structured debt markets for the first time, Wall Street's bond machine will keep humming.
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