Downside Risks in the Mortgage Market

Published April 7, 2020

The COVID-19 pandemic is not a housing crisis in its nature, but there are several places throughout the industry where the pandemic or policy response to it has hit at some vulnerabilities in the market. For the most part, these vulnerabilities tend to be when normal, slightly adverse events start occurring in large numbers nationwide. This strains a system that is designed to be able to withstand a certain amount of adverse conditions but can completely seize up if that threshold is crossed. Some of these policy responses are “well intentioned” but that doesn’t mean that they don’t have unforeseen consequences.

Margin Calls

The Federal Reserve (Fed) buying unlimited quantities of agency mortgage backed securities (MBS) had the desired effect of keeping liquidity in the market and keeping it from crashing, but they may have gone a bit too far. The sudden increase in MBS prices due to increased demand from the Fed had the unforeseen consequence of margin calls for those hedging and investing in the MBS space. Large amounts of margin calls, in what is generally a fairly cash strapped and highly leveraged area, can cause short term insolvency, missed margin calls, and long run bankruptcy if no other solution is found. This weakens the secondary market for mortgages which in turn hurts the primary market.

Unemployment

Unemployment is increasing, and drastically! The impact of that is expected to be blunted by the CARES Act but we will still likely see increasing delinquencies, particularly in the short term. FNMA and FHLMC have come out with guideline on a deferral and some increased forbearance guidelines, as well as encouraging modifications when appropriate. However, there will still be a rise in delinquencies. One of the looming concerns is that the servicers will not be able to make all of the advances necessary to the investors, similar to margin calls leading to short-term insolvency, and potentially long-run bankruptcy.

Foreclosures & Evictions

Many governors and agencies have temporarily halted foreclosures and evictions. To a certain extent, this makes sense from a public health social distancing perspective. But for the “investor” or owner of the property, it is extending the amount of time that they are losing money – and often still owing themselves if it is a rental property – with no income and increasing costs when this is over. To make matters worse, the courts will likely be flooded with cases when they reopen for foreclosures which could further strain the landlords and investors. As the foreclosure backlog clears, it will also be putting a larger number of distressed houses on the market at the time.

Payment Advances

Some states[1] are simply suspending mortgage payments. New York suspended mortgage payments for 90 days by law. California negotiated for a three-month deferral with five large banks[2] for those impacted. Also, there is a provision in the CARES Act for forbearance for 6 months, renewable for another 6 months. Mortgage servicers may be facing a liquidity crisis as they may have to advance payments and interest to investors depending on their servicing agreement. Whether the borrower has a payment deferral, suspension, or forbearance, the cash flows coming in will be greatly reduced. The cash outflows are likely to not be similarly reduced. If this liquidity risk becomes too great, servicers may start to have to start selling off their assets (known as a “fire sale”) which may get them through but may lead some to bankruptcy.

Rental Properties

Rental markets may collapse, particularly in touristic areas. The market for short-term rentals has been decimated because no one is travelling. This means that the owners of these properties may be among those going delinquent or defaulting on their mortgages. It also means that some of them are entering the more traditional long-term rental market. As the supply of available units to rent increases, the rent for each is likely to be depressed, helping renters and hurting landlords. If this effect is large enough, some landlords may start selling as the rents will no longer cover their costs, increasing the houses for sale and potentially decreasing property values, which could in turn decrease rents further.

New Purchases

Finally, right now people just aren’t moving. It remains to be seen how this will impact the home values in the long run, but at the very least it will lead to some interesting market dynamics when the purchase market starts to pick back up. There will be a lot of pent up demand and likely the supply to match, but we may see a little purchase boom later in the year, especially if rates are still low.  

There are many downside risks in the mortgage market and industry at the moment. Hopefully, we will be able to flatten the curve and reopen the economy before some of these come fully to fruition. The government intervention thus far has been a bit of a double-edged sword because it has been “solving” one problem but “causing” another. There is one thing that I can say with almost absolute certainty though, to have a healthy economy, you need a well-functioning stable housing market.


Sources & References

[1] NY and to a certain extent CA so far. Potentially more to come
[2] Bank of America agreed to one month at a time

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