Many investors know about US subprime lending from 2004 to 2007, and the infamous NINJA loans, where the borrowers had no income, no job and no assets. They were a marker of the crazy lending in the US, and it became a major factor in causing the GFC. Although second mortgages were common in Australia prior to deregulation in the 1980’s, a far more important development in the boom leading to the GFC was the ‘silent second’ mortgage. At the late stages of the boom, it was estimated that 35-40% of US home buyers had both first and second mortgages. The presence of a second mortgage was often not disclosed, hence the name ‘silent’.
How do buyers raise their deposits?
For borrowers who have a decent income but don’t have a good deposit, there are three main options:
- a gift from their parents to cover the deposit
- a high loan to value ratio (LVR) loan with lenders mortgage insurance
- taking on a second mortgage.
In some cases, the gift from the parents isn’t really a gift but rather an undocumented loan that everyone hopes can be repaid at some point in the future.
In Australia, residential lenders frown upon second mortgages, and will often refuse to be the primary lender if the borrower is intending to have a documented second mortgage. The paperwork involved and the potential legal hassles if the loan goes bad simply aren’t worth the effort. The lack of a formal second mortgage lending market in Australia (which is arguably a good thing) encourages some borrowers to pursue silent second mortgages. Most often this comes from drawing down on undeclared credit cards or personal loans to ‘create’ a deposit.
Second mortgages can stretch borrowers
However, some Chinese borrowers are being offered the opportunity to obtain a second mortgage and purchase an Australian property without necessarily having a deposit. For example, the second-largest insurance company in China by premium income, PingAn Insurance, offers loans to Chinese investors for Australian residential property at real estate conferences in Shanghai. The Chinese borrowers will use the second mortgage as a deposit for an off the plan apartment, with the expectation that a senior loan will later be obtained from an Australian bank to pay the final 70% when the apartment is completed. This is a potential landmine for all involved.
Second mortgages can be deadly for the primary lender, the property vendor and particularly the second lender. For the primary lender, the second mortgage reduces their risk of loss if the borrower defaults as it increases the buffer between the house price and the primary loan. However, it dramatically increases the risk that the borrower will default. Borrowers are often stretching their income to cover two loans, with the second loan often having an interest rate above 10%. The property vendor has received a solid deposit, but the risk of a failed settlement is higher and that means that the developer may be forced to re-sell the apartment, possibly at a lower price. There could be many apartment buyers in the same building using second mortgages, with the potential for the developer to be hit with a higher than usual number of failed settlements. There’s nothing like an overhang of supply to depress prices.
For second mortgage lenders in the US in the subprime era, it was a classic ‘picking up pennies in front of the steamroller’ investment. The higher yield on the loans looked attractive, but the much higher default rates and the abysmal recovery rates meant losses were substantial. Notwithstanding the experience, originations in the US are picking up again but this time around the subprime portion is currently less than 1%.
We should know more about silent seconds
I’m not aware of any research into the presence of silent seconds in Australia. It is generally known that some borrowers are not declaring their credit card debts, personal loans and peer to peer/marketplace loans, but the prevalence is very difficult to know. The voluntary nature of credit reporting in Australia makes it much harder for lenders to know when borrowers have other debts outstanding. It will probably take a crisis before politicians and regulators understand the importance of compulsory credit reporting of both positive and negative incidents. (Positive reporting shows that payments have been made on time, negative reporting shows payments missed.)
Jonathan Rochford is Portfolio Manager at Narrow Road Capital. This article is for educational purposes and is not a substitute for professional and tailored financial advice. Narrow Road Capital advises on and invests in a wide range of securities.