If you could stop paying your mortgage today with virtually no consequences, would you? This very question is posed to many American homeowners right now, and it seems to be a no-brainer! 

In a necessary move by Congress to contain the horrendous and immediate economic damage caused by the COVID-19 crisis, the CARES Act mobilized sweeping protections, cash payments, and deferrals of many large cash flow obligations for individuals impacted by the crisis. Most pertinent to mortgage investors is the provision that borrowers can seek forbearance for up to 12 months with no documentation, fees, penalties, or additional interest. With unemployment surging towards 20% nationally, there is no denying that some measure of relief is vital so that American families can stave off financial catastrophe – but when is the cure worse than the disease? Just as unsustainable monetary policy over the past decade fostered dangerous amounts of leverage and fueled a “central bankers’ bubble” that decoupled asset prices from the growth of the economy, the government subsidization of the mortgage market will likely result in unintended consequences down the road.

With the potential for mortgage forbearance on a scale never seen before, and the possibility for widespread permanent modifications on the horizon, it appears that this newly enacted government policy could lead us to a real estate and mortgage market that is massively and continually subsidized. To see the deleterious consequences of subsidized markets, we need look no further than financial markets over the past decade. Relentless central bank stimulus has conditioned market participants on moral hazard: binging on low-cost credit today, leveraging corporate balance sheets using borrowed cash to buy back stock, and relying on a Fed “put” to ensure market support during stressed periods. The result is a fragile economic system propped up on cheap credit and quickly toppled by a single meaningful shock. Is it unfair to compare the actions of corporate management over the past decade to the American consumer today? We think not.

Monetary Policy Over the Past Decade Has Decoupled
the Wealth Economy from the Income Economy

Source: Bloomberg, TCW

The moral hazard risk in allowing economically stressed borrowers to defer mortgage payments has never been higher. For borrowers whose loans are in pools backed by the agencies, or 70% of the mortgage market, forbearance is literally a few clicks away, requires no documentation, is interest free, and does not affect their credit scores! The result? Forbearances and delinquencies have risen rapidly since the CARES Act was signed into law – by the end of April, Fannie Mae reported that 7% of its single-family loans were in forbearance and predicted forbearance rates could reach as high as 15%. How many borrowers who still can make their payments will take advantage of these policies anyway? With minimal real cost, the study of behavioral economics suggests that many folks will do so.

Percent of Servicing Portfolio in Forbearance

Source: MBA Forbearance and Call Volume Survey, Bank of America

More importantly, at the end of the forbearance period, how many borrowers will return to paying their normal mortgage payment, especially in an economy with likely higher unemployment and lower incomes? Even if many of the borrowers who were temporarily unemployed come back into the workplace in this new economy, we suspect that many will need (and want) a more permanent modification on their existing loan. Ironically, many borrowers may find themselves shut out of traditional refinances after forbearance, as lenders generally require borrowers to be current, paving the way for more modifications post crisis.

The fundamental tenet of financial markets is that there is no such thing as a free lunch, and so, we must ask who is picking up the tab for the generous forbearance policies afforded to borrowers. To answer this question, we must dive headfirst into a rabbit-hole…

Servicers are among the first to take a hit. While a borrower is in forbearance, the mortgage servicer continues to be responsible for advancing scheduled principal and interest payments. Given how easy it is for borrowers to enter forbearance, the risks to servicers (especially those that lack access to cheap funding) are potentially significant, and systemic servicer solvency issues could disrupt the primary mortgage market. In the end, stress in origination channels would culminate in more challenging refinancings and higher mortgage rates for borrowers

Eventually, the GSEs and Ginnie Mae would be forced to pick up the slack. Ginnie Mae has expanded its Pass-Through Assistance Program to support servicers facing a liquidity shortfall in meeting their advancing obligations, while the GSEs have announced programs to assist servicers by limiting the amount of servicing they have to advance to four months (after which the GSEs would step in and continue advancing). These advancing obligations are potentially substantial with an undefined recovery timeline, as borrowers have the ability to defer all forborne payments until loan maturity, modification, or the sale of the property. In addition to advancing on forborne loans, the GSEs would have to fund any loans that require modification. The process involves “buying out” the loan from an existing agency guaranteed pool, and effectively creating a new modified loan that would be held on balance sheet. If the borrower begins making payments again, agencies can re-pool the new modified loan and sell it back to the market; however, should a borrower default, a lengthy and often costly foreclosure process would ensue. To fund these activities, the GSEs will likely pursue some combination of issuing more debt after seeking approval to expand borrowing limits and drawing down Treasury credit lines. In short, generous forbearance policies opens the door to funding issues and potential losses that would ultimately be borne by the agencies.

At this point, any expectation for the GSEs’ smooth transition out of conservatorship has surely been dashed or delayed, meaning taxpayers would continue to backstop the mortgage system. The costs to individuals do not stop there – while the government has issued trillions of additional debt to cover the immediate needs of this and other temporary programs, the repayment of this debt has not been a focus. We can be sure that future American taxpayers will eventually pay for these costs in one form or another.

Investors are certainly on the hook as well. The current climate is one where a host of nebulous risks abounds – the path of economic recovery is uncertain, the future unemployment rate is unknown, and policies adopted so far have painted no clearer picture on the future trajectory of prepayment speeds. What’s worse, proposed policy responses have raised more questions than answers, from deferral plans for borrowers’ entire forborne payments that could slow down prepayments, to expanded modification and refinance programs (akin to those seen during the global financial crisis) that could result in large scale buyouts, each threatening to wrench the prepayment speed “tug of war” to one side. Case in point, to the extent buyouts are widespread, whereby investors get back par on the portion of the pool that is bought out, current investors stand to lose significant yield and total return on agency MBS pools as the average price of a pool is over 105% of par. With no end to the uncertainty of valuations in sight, investors may well begin to demand higher discount rates for investing in mortgages, a cost that would ultimately be passed on to future borrowers.

Finally, we must think about the new homebuyer. Did the government unintentionally freeze the real estate market with generous forbearance policies? Now, borrowers who cannot pay are not forced to sell, and would-be homebuyers must either wait, or pay a likely inflated price. As often is the case for private transactions in subsidized markets, the results usually lead to wider differences between price levels of willing buyers and sellers, fewer real estate transactions and greater difficulty for the next generation of homebuyers to enter the market at affordable levels. What about renters? Many states have since suspended evictions for the non-payment of rent. This too is unsustainable as the owner of the home or apartment has expenses as well, spurring even more forbearance requests. Down a rabbit-hole indeed!

The mortgage market is a delicate ecosystem, one designed to provide fair mortgage rates so that consumers can realize the dream of home ownership. It is built on the symbiotic relationships between the government, servicers, borrowers and investors. However, these relationships are upended when parties are no longer incentivized to act fairly and free markets cease to function. While many of the recent COVID-19 policies may have been necessary, they could potentially throw this ecosystem off balance and the tragedy is that the aspiring homebuyer ultimately stands to lose the most.