APRIL 2020
A Cloudy Crystal Ball
Market and Housing Finance Impacts of COVID-19
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The Short Version
It has been an incredible start to 2020, one most of us will never forget. Never has our economy or normal daily life been uprooted so quickly and viciously due to a force generally out of our control. Markets were extremely volatile, the Federal Reserve poured trillions of dollars into the system, the mortgage system is frozen, levered investors washed out, and mortgage servicers potentially in big trouble. The rest of this post will discuss all of the above in detail as well as provide commentary on possible outcomes within housing finance.
Markets
Q1 was an extremely volatile quarter in global markets with equities hitting all-time highs, plunging back to 2017 levels, then ripping back to levels just seen last year, almost 30% higher in a matter of weeks. Likewise, the 10-year U.S. Treasury Bond briefly hit an intraday low below 0.40% in March before rising back into the 0.65% area. These whipsaw markets have had an extremely adverse effect on fixed income market liquidity, particularly the most levered sectors.
Fed to the Rescue
As investors have become accustomed to over the past 13 years, it didn’t take long for the Federal Reserve and Treasury to step in to bail out markets with several “bazookas”. Prior to the market rout, the Fed instituted an emergency rate cut of 50 basis points on March 3rd, followed by another emergency 100 basis point cut on March 15th (Sunday). The Fed Funds target now sits at the zero-bound, 0–0.25%.
Following the emergency rate cuts, the Federal Reserve and U.S. Treasury began their parade of acronym-linked programs with the first significant phase announced March 23rd and second phase on April 9th. The list below includes announced programs with Fed and Treasury commitments.
Two of these programs are focused on small and medium-sized business lending ($949 billion), one facility supports state and local government financing ($500 billion), and the majority of actions are geared towards primary and secondary market operations ($1.55 trillion).
With most of these emergency programs yet to launch, the Fed’s balance sheet is likely to expand drastically over the coming weeks as the Fed provides all-out support for the fixed income market plumbing. The initial wave of securities purchases may be seen on the Fed’s balance sheet, now with total assets of $6.4 trillion, up from $4.2 trillion on March 4th.
Residential Mortgage Market
While the Fed is hyper-focused on fixed income market operations, specifically for corporate and asset-backed issuers, the housing finance response has been focused on government-backed loans. The Federal Housing Finance Agency (FHFA) and the GSEs (Fannie Mae, Freddie Mac, Ginnie Mae) announced in early March they would provide hardship payment forbearance for government-backed loans whose borrowers were affected by COVID-19. Borrowers may defer payments for 12 months, at which point mortgage servicers will work with borrowers to address payment options.
The FHFA advised Fannie Mae and Freddie Mac to implement a number of additional measures, including:
· Suspending foreclosures and evictions for a 60-day period
· Eviction protection for renters in government-backed multifamily properties
· Additional liquidity provisions for the secondary market
· Flexibility on appraisal, employment verification, and remote notarizations
While these measures will assist borrowers in government-backed loans, the remainder of the mortgage market has been abandoned. Numerous banks have announced they will also support payment forbearance, but there has been no nationwide program to support the Non-Agency, or Non-Qualified Mortgage, market and its borrowers. A number of banks have even shut down high balance, “Jumbo”, lending typically reserved for high-quality borrowers.
Given the lack of support for the non-government backed mortgage market, underlying loans and securities have experienced extreme price volatility not seen since the financial crisis. Investors are unsure of payment timelines, forbearance amounts, and ultimate defaults, thereby pricing assets to include significant margins of safety. Historically, once underlying asset prices fall the ripple effects are felt throughout the system. This is exactly what happened again this time.
Levered investors received margin calls due to lower-priced assets and were forced to post additional collateral or cash. Liquidity facilities and warehouse lines have been pulled. Securitization markets have come to a screeching halt, leaving lenders holding loans on balance sheet and unable to purchase new loans. New loans in the pipeline are either canceled or on hold. Borrowers attempting to refinance into historically low mortgage rates have been denied. As we stand here today, lenders are shutting down and the market is completely frozen.
Mortgage Servicing Industry
One part of the mortgage market which receives little attention is the mortgage servicing industry, until now. The servicer is responsible for collecting payments from borrowers, then delivering those payments to the ultimate loan holders. Servicers also provide a borrower contact point, default management services, loan workouts, and administrative duties related to each loan. A less understood piece of the servicer’s responsibility is the concept of advancing.
Servicer advancing is the responsibility for a servicer, in most cases, to “advance” principal and interest payments to loan investors on a delayed monthly basis. In these instances, the servicer is responsible for delivering payment regardless of whether the borrower has actually paid that month. To do so, the servicer would draw down a liquidity facility, advance the payment to investors, then attempt to collect the payment from the borrower as soon as possible. The servicer is responsible for advancing these payments as long as advances are deemed “recoverable”, or servicers believe they can recover the funds from the borrower eventually (through short-sale, foreclosure, or another workout if necessary). Once the payment is collected, the servicer is paid the advance amount and pays down its liquidity facility proportionally.
Why is this important? When the Federal Government and other institutions provide a 12-month hardship forbearance for borrowers affected by COVID-19, servicers are often still required to advance the forbearance principal and interest to loan investors. Given the amount of residential mortgage debt outstanding in the U.S. stands over $11 trillion, the cost to advance on a small number of loans would put numerous servicers out of business as liquidity facilities cannot support these drawdowns.
The Mortgage Bankers Association (MBA), industry groups, and companies are currently lobbying Congress, Treasury, and the Fed to provide additional liquidity to mortgage servicers. Ginnie Mae has announced it will provide support for its loans, while Fannie and Freddie have expressed interest in providing support but has not been finalized. Non-government loan servicers, and non-bank servicers, appear to be orphaned for now.
The lack of clarity in mortgage servicing, advance capabilities, and overall non-bank support has also been a contributor to the volatility in asset pricing. Until liquidity is provided, or servicing is moved to bank-owned operations, the system will remain clogged.
A Cloudy Crystal Ball
While it is difficult to predict what will happen over the next few months, it will be important to watch data closely to determine both consumer and economic financial health. The key variables include:
· When will the economy reopen and how many businesses will remain closed permanently?
· How many unemployed workers will re-enter the workforce, and what is the timeline?
· What does the consumer balance sheet look like on the other side of this crisis?
Considering these questions, we can estimate outcomes for the economy and more specifically the housing industry. In all scenarios, the process of returning to normal will likely take longer than we anticipate. Even if businesses are able to open mid-May or early-June (extremely optimistic), it will not make sense to ramp up headcount until businesses have confidence customers will return. For hospitality, entertainment, and travel, this timeline will be significant. Given 22 million people have filed for unemployment in the past 4 weeks and others are spending savings on every-day expenses, it may take months or years for consumer and business spending to return to 2019 levels. Additionally, the longer we stay closed for business, the longer it will take to recover as more businesses become marginalized and may be forced to pare back or close.
While business timeline and unemployment levels are key to economic recovery, housing is in a unique situation. Going into Q4 2019, Black Knight calculated homeowner equity reached an all-time high of $6.3 trillion. Borrowers have significant equity in their homes, and now a vast majority of borrowers have the ability to forbear payments for 12 months through GSE programs. Any immediate impact on housing will likely come from the non-agency market, which typically includes self-employed borrowers, high balance loans, investment properties, second homes, and other non-traditional loans.
The first set of key data will be released in May (for April payments), and it will be a glimpse into how many borrowers made, missed, or forbore payments. An even better picture will be presented in June and July, once consumers have been dealing with the current environment for a few months. Additionally, it will be key to watch credit card and auto delinquencies over the next few months to get a full picture of the consumer. If data show a significant number of borrowers are able to keep making payments and the economy is able to open relatively soon, the effect on housing and lending may be shorter-term. Some people may even decide they want to relocate or move after being in their homes for 2 straight months, especially if companies provide more options to work from home.
While a short-term impact is optimal, a more likely scenario is a 6–18 month freeze in housing. Lenders and loan investors will pause with economic and home price uncertainty, particularly with unique borrower situations. The government, through GSEs, will be the lender of choice for borrowers and loans that conform to GSE standards. Banks will likely pull back from balance sheet lending as loan loss provisions spike across all industries. The question is where this leaves home prices in 12–24 months.
To tackle this question, one additional factor must be considered, inflation. Given drastic government intervention across all markets and the amount of debt accumulated to do so, there may be a point in the short-to-medium term where we have increased inflation expectations on the long end of the yield curve (10–30-year U.S. Treasury Bonds). Increased long-term rates would drive mortgage rates higher and slow homebuying activity considerably as monthly payments increase. The increased cost of borrowing could further drive an illiquid market for those homeowners looking to sell. While this scenario may not play out, it must be taken into consideration.
The most likely outcome, at the least, is homebuyers will seek discounts due to uncertainty and lack of financing options. Depending on the seller’s situation and amount of equity in the home, he or she may stand strong on price or sell lower if necessary. There will be a widening bid/ask spread for home prices with any transactions likely completed closer to the bid-side. In a steady, low interest rate environment, the bid-side level could conceivably be as much as 10% lower. If interest rates rise due to inflation or overall market uncertainty, the clearing level could be closer to 20% lower. To be clear, these estimates represent transactions in which the seller must transact. Most likely, sellers would refrain from such a discount if possible.
If anything is crystal clear at this point, it’s that none of us really know how this will play out. We can, however, make educated projections based on probability-weighted outcomes and plan accordingly. Until we have clarity on the key questions above, expect all projections to be cloudy.
Liquid Insights is a quarterly publication distributed by Liquid Mortgage, a digital asset and payments platform for traditional loan products. To reach out for more information or comments, please email info@liquidmortgage.io.
*Data Sources: St. Louis Federal Reserve, FRED Economic Data
