Watch For A Rise In Mortgage Foreclosures

Summary

• Bankruptcy activity has been remarkably low in 2020 thanks to loan forbearance programs in the CARES legislation.
• Absent further action by Congress, these programs will expire in 2021. Borrowers must then resume payments or face foreclosure or default.
• Data shows that mortgage delinquencies are approaching 2009 levels and are far higher than in previous recessions. This suggests a tsunami of foreclosures and bankruptcies could hit in 2021.
• Banks made large loan loss provisions earlier this year, but they are still far lower than 2009-10. We expect these will be necessary to cover likely loan losses, and additional provisions may be needed.

Market Implications

• Financials – Financial equities may remain under pressure until we get better visibility on the full extent of loan portfolio delinquencies and potential losses.
• Asset- and Mortgage-Backed Securities – Triple-A tranches should be protected, but mezzanine and subordinated tranches will be subject to widening spreads and losses as bankruptcies and foreclosures rise.

The CARES Act loan forbearance programs have done much to ease the economic pain of the 2020 Covid recession. They have been so successful that bankruptcy activity in the US has actually declined since the Covid lockdowns started in March (Chart 1).

Under forbearance programs, borrowers could suspend loan payments without being subject to foreclosure or impairing their credit rating. Sadly, forbearance is not forgiveness. Unless Congress extends forbearance programs, they will soon expire.^[1] Borrowers must then resume payments and make arrangements to repay missed instalments.

Judging from the limited loan delinquency data currently available, many people appear to have taken advantage of loan forbearance programs – at least in the mortgage arena.

Mortgage Delinquencies Are in Sight of GFC Levels

In its latest quarterly survey, as of September 2020, the Mortgage Bankers Association found that total delinquent mortgages jumped to 7.9% versus 4% pre-Covid (Chart 2). This is well below the late 2009 high of 10.4% – but also far higher than any previous recession since 1979. More troubling is that severe delinquencies (more than 90 days) are at 4.6%, not far below the 2009 high of 5.1%. Note that foreclosures have been declining recently due to forbearance programs.

Conventional mortgages pooled or owned by Fannie Mae and Freddie Mac are a second source of mortgage delinquency data. The story here is similar (Chart 3). Delinquencies are roughly a percentage point below 2009-10 highs but also far higher than any time before.

We would ideally look to the FDIC or Federal Reserve for credit-related performance on a broader range of loans. However, thanks to the forbearance programs, banks are not reporting Covid-related delinquencies as impaired for now. Historical experience suggests that bank loan portfolios tend to suffer high delinquency levels during stressful periods (Chart 4). During the 1980s, delinquencies were concentrated in real estate and commercial and industrial (C&I) loans. The 2002 bulge was largely C&I loans. The GFC spike was largely real estate loans, although C&I loans reached levels similar to those of the 1980s. Our working assumption for now is that bank loan delinquencies have risen sharply, probably in line with residential mortgages.

What Can We Expect as Forbearance Programs End?

We will assuredly see a jump in foreclosure and bankruptcy activity. At worst, it could approach levels seen after the GFC. Then again, delinquency data may be painting too bleak a picture. It is possible that some people who could have kept making mortgage payments elected to enter forbearance to save money as a hedge against losing their jobs. They should soon be able to repay what they owe. Also, people who were furloughed then recalled may struggle but will ultimately avoid foreclosure. But unless the high level of structural unemployment soon falls, a sharp rise in foreclosures will be inevitable.

Given poor visibility regarding bank loan portfolios, the level of uncertainty is high. Banks did make significant additions to their loan loss reserves in the first and second quarters, bringing them to 2009 levels (Chart 5). But because the percentage of loan loss reserves is currently only 2.2% versus 3.5% in early 2010, we would be unsurprised if banks have to increase reserves further once they resume classifying Covid-caused nonperforming loans as impaired. At the very least, we expect most of those loss reserves will be needed to cover chargeoffs. Translation – they are unlikely to be released into future earnings.

Do Markets Care?

Equity markets have shown a remarkable ability to look past any Covid-related impediments and price in a full recovery. It is quite possible that they will overlook any significant increase in bankruptcies and foreclosures too. Most of these will affect smaller companies that do not trade in the public equity markets. If there is an impact, however, it may be due to poor visibility on the magnitude of the problem which becomes a drag on economic growth for longer than expected. But given how resilient equities have been, this could simply result in trading range behaviour rather than a significant selloff.

We do expect banks and financials to underperform especially if it turns out they need to add to loan loss reserves.

A sharp rise in impaired loans and foreclosures and bankruptcies could weigh on the securitization market. Triple-A tranches of MBS and ABS structures should be secure, but mezzanine and subordinated tranches could be subject to widening spreads and losses.

1. Loan forbearance programs vary but were set to run about six months or through to the end of 2020. Mortgage forbearance programs provided a six-month window, with an option to extend for another six months. ↑