Rather than a systemic collapse of the subprime market that sparked the last recession, the Covid-19 crisis has morphed into a slower moving period of distress exacerbated by economic shifts that have left corners of the market particularly vulnerable to new seismic events.
A decade after the financial crisis exposed deep cracks in the foundation of the residential mortgage market, the sector is widely considered to be safer than it was, shored up by regulation and tighter underwriting among lenders. The market is also a more accurate reflection of the US borrower landscape, with a range of mortgage products packaged into RMBS deals and marketed to investors with varying risk appetites.
But a problem cropped up in the early weeks of the pandemic that highlighted issues stemming from shifting the balance of mortgage lending and servicing from large banking institutions to non-bank entities. Since the financial crisis, non-bank servicers account for nearly 50% of the market, compared to around 13% in 2008, according to data from the Housing Finance Policy Center. As borrowers were furloughed, laid off or had working hours reduced in March and April, many turned to their lenders to negotiate a potential pause in their payments. Servicers, who must advance principal and interest to investors and many of whom do not have a cushion of depository cash, were suddenly facing a liquidity crisis.
The Federal Housing Finance Authority (FHFA) stepped in with a fix in April, telling servicers they are only on the hook to advance payments on loans in forbearance for four months. Yet, sources say it is still a top concern for the market, as many borrowers may end up exiting forbearance just to go delinquent on their mortgage once they are due to start making payments again.
Servicer liquidity is part of a patchwork of concerns about the ability of the wider market to withstand the long term effects of the coronavirus.
“If these early issues are not addressed, they threaten to pose much deeper problems under the second wave of stress to come, as job losses become permanent and many borrowers go from forbearance to foreclosure,” wrote Laurie Goodman at the Urban Institute’s Housing Finance Policy Center in a paper in May.
Hidden stress
Many of the Covid-era government protection programmes will run out this summer, including additional unemployment benefits that gave an extra $600 a month to jobless Americans. The intense stress on US household balance sheets is for now masked by the forbearance figures, which many expect to at least partially translate into actual delinquencies by the third quarter.
As of May 26, 4.76 million mortgage borrowers were in forbearance, according to data firm Black Knight, although a slight decline was observed in the period from May 26 to June 2 among borrowers with loans from one of the government sponsored enterprises.
The wider markets, meanwhile, are interpreting a host of conflicting signals. Stocks soared in the second week of June on the back of positive employment data, only to crater days later after a discouraging address by Federal Reserve chairman Jerome Powell. He told anxious markets to expect rates near zero through 2022 and that the central bank would expand its already massive bond buying spree. On June 11, the Dow Jones Industrial Average was down over 1,800 points, rivaling the worst selloffs seen in the earliest days of the coronavirus outbreak.
For mortgage finance players, sources say the summer will bring a mix of hope and fear if job losses become permanent and if a recovering market runs into another outbreak of Covid-19 in the autumn.
One RMBS investor says the prospect of a second wave of infections is his “worst fear” for the economy broadly and for housing specifically.
“I have a hard time seeing the situation improving in the near term. There is still pain to come, which Powell alluded to, but I think investors need to be very watchful. I wouldn’t be caught out at the edges of some riskier products right now,” the investor says.
Reflecting that sentiment, a flight to quality has been seen among RMBS buyers in the months since the pandemic began, according to Urban Institute researchers.
“Although it is too early to know what the fallout from the Covid-19 crisis will be on mortgage credit quality, with unemployment surging to levels not seen in a generation, investors in every corner of the mortgage market are pulling back aggressively on their exposure to credit risk,” wrote Goodman.
The combination of intense shocks to the housing market and dwindling investor participation are leading to lower issuance forecasts across the board for non-agency RMBS products. In its mid-year outlook, JP Morgan revised every non-agency sector lower for the full year, with total private label issuance projections going from $55bn in January to $37bn.
New world for CRE and CMBS
While the problems in residential mortgages are rooted in the employment crisis, the commercial real estate market is dealing more with the effects of social distancing, which has upended everything from retail, to hospitality to office space.
Retail was an early casualty of the crisis. Already struggling in the face of competition from e-commerce, the shuttering of non-essential businesses across the US was the nail in the coffin for many brands. JC Penney, Neiman Marcus and JCrew are just some of the names that have filed for bankruptcy since the outbreak, and Deutsche Bank CMBS researchers have identified nearly 3,200 stores occupied by 13 retailers set to close.
For hotels, the sector has been the largest driver of commercial mortgage transfers to special servicing, with landlords going delinquent on payments thanks to a sharp decline in revenue per available room (RevPar), which fell by 80% in April.
CMBS, though, has adjusted, with deals scrubbed of all exposure to hotels and including only high quality retail. Lenders have also stocked deals with more multi-family, competing more heavily with Fannie Mae and Freddie Mac which historically dominate the space.
“Recent CMBS deals have actually been very well received,” says Dan Lisser, managing director at commercial real estate services firm Marcus & Millichap in New York. “They’ve been pushing really hard on multi-family because it really helps them with the rating agencies.”
Sentiment is improving with the arrival of summer. Where spreads on benchmark triple-A CMBS were out to nearly 300bp over swaps at the start of the pandemic, they have come back into around 130bp, still a way off from the 2020 tights of around 92bp, but improving. Loans are also being quoted tighter again. A debt broker tells GlobalCapital that between the first and second week of June, quotes for the same CMBS loan on a grocery-anchored retail asset came in tighter by 20bp and leverage offered went from 60% to 65%.
Office space is a bigger unknown for CRE professionals. It is possible that working from home has sparked a permanent change, and office tenants may take much less space in future. There are other uses for offices but the space is not easily converted, and sources say it would take years to repurpose an office into apartments or other mixed use space.
“There are two schools of thought,” says Lisser. “One is that, yes, people will use less office space. The other is that tenants will actually need more space for the same number of people because of social distancing.”