The financial crisis of 2008 was caused by homeowners defaulting on their mortgages en mass thanks to risky loan products that were destined to fail. The bonds those mortgages were bundled into collapsed in value as a result, and it brought the entire financial system down with it.
With the stock market tanking and unemployment skyrocketing, is the economic fallout of COVID-19 about to cause history to repeat?
Earlier in March, the Federal Housing Finance Agency (FHFA), which regulates mortgage facilitators Fannie Mae and Freddie Mac, directed mortgage servicers of Fannie and Freddie mortgages to offer mortgage forbearance or reduced payments to homeowners impacted by the novel coronavirus.
While a separate directive from the FHFA put a moratorium on foreclosures and evictions of homeowners whose mortgages are owned by Fannie or Freddie, the potential fallout in financial system has not yet been patched. Mortgage bonds are still disbursed to hedge funds, pension funds, and elsewhere.
What happens this time when mortgage payments stop flowing into mortgage bonds?
“I think what’s scary about it is what the last recession crisis taught us is just how intertwined so much of financial markets are,” says Patrick Boyaggi, CEO of mortgage marketplace Own Up. “You don’t just see something like this happen and there not be a ripple effect throughout the economy.”
Homeowners are protected by the FHFA directives. Mortgage servicers—the companies that collect payments from borrowers and disbursed the payment to investors in mortgage bonds—are still on the hook to pay investors, even if borrowers stop making payments. The company that handles payments can vary: it is either the bank or lender that issued the mortgage, or a separate company that specializes in servicing mortgages. Among those banks are the biggest in the country—Citi, JPMorgan Chase, Wells Fargo.
If Congress and regulators don’t intervene—and fast—some mortgage servicers, banks, and lenders will have to dip into capital reserves that are insufficient to cover these payments over the long term. Some will have to shut down entirely, at least temporarily.
If mortgage servicers fail, there is no one to collect mortgage payments and disburse the money to investors of mortgage bonds. The entire mortgage infrastructure would collapse and investors would be holding potentially worthless mortgage bonds. Banks servicing loans and/or holding mortgage bonds would be short on the cash that they typically lend to homeowners.
The contagion that would cause in the financial system is impossible to know—but it could potentially be devastating. Mortgage lending could come to a halt. Pension funds could take yet another hit. It could make the economic recovery after the pandemic take even longer.
The good news is federal regulators and lawmakers are aware of the problem and working to fix it. Ginnie Mae, which deals mostly with affordable mortgages, has announced its intent to address the problem in the next two weeks. The Federal Reserve has already purchased $214 billion worth of mortgage bonds in hopes of stabilizing the market. Language to address this problem was included in the House draft of the relief bill that passed on Friday, but it didn’t make it into the final bill.
The other good news is this is a fairly straight forward cash-flow problem. Mortgage servicers need cash in order to make payments to mortgage-bond investors, but they are not getting that money because of the mortgage forbearance directive from FHFA. The solution proposed in the House draft of the relief bill was for the Federal Reserve to extend a line of credit to mortgage servicers to cover their near-term cash flow problem.
“[Regulators and lawmakers] are aware of the issue and I think there’s generally consensus about the path of least resistance on some of this, but it has to happen,” says Andrew Jakabovics, vice president of policy development at Enterprise Community Partners. “That’s where we are at the moment, waiting for that to become official, this clarity and certainty.”
The bad news is that federal regulators and the industry are swiping at each other over the appropriate response. Servicers want a line of credit to continue making payments. Mark Calabria, director of the FHFA, wants to transfer servicing rights away from struggling servicers to “other parties,” and even called the industry’s alarm over the situation “spin.”
The economic fallout of COVID-19 has caused similar and equally catastrophic problems for practically every industry in America, and they’re all lobbying hard to get their fix written into what will no doubt be more relief packages passed by Congress. Whether the mortgage industry breaks through the chaos and gets its fix before another industry does is anybody’s guess.
The longer it takes for lawmakers and regulators to act, the worse the problem will get and the harder it will be to fix it. While the Federal Reserve setting up a line of credit to mortgage servicers sounds fairly simple, it still takes time, which is already strained because of everything else happening. A month could be too late for many servicers.
“There’s been a hair-on-fire level of outreach to every part of the administration and Congress from not just the industry but consumer groups that realize the implications of all this,” says Jim Parrott, a nonresident fellow at the Urban Institute and owner of Falling Creek Advisors, a housing finance consultancy. “The $64,000 question is given all the other industries that are probably saying something similar, how do we prioritize which sectors of the economy that are all in need of these credit facilities?”