Coronavirus economic threat -- A mortgage industry calamity is looming

Under the CARES Act, Congress has invited millions of Americans to stop paying their mortgages

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The coronavirus pandemic is perhaps the single biggest crisis to hit the U.S. economy since the 1930s. Large swaths of the U.S. economy have been idled and particularly the services sector is being decimated in a way that harkens back to the Great Depression. Double-digit unemployment seems inevitable by June, with all of the attendant economic and financial consequences.

Amidst this chaos and dislocation, the U.S. housing industry should be a bulwark upon which the economy may find support. After all, virtually all residential mortgages and many multi-family commercial loans in the U.S. are government-guaranteed, right?

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Correct, but a series of missteps and outright errors in judgment by federal regulators are turning a bad situation in housing into a calamity that may lead to a U.S. debt default.

The mortgage industry is essentially a large cooperative network. The homeowner pays the mortgage. The bank or nonbank loan servicer transfers the payment to a bond investor and retains a small fee. The loan servicer also pays the property taxes and insurance on the property, protecting not only the home but the municipal finances of communities around the country. The total flow of interest, principal, taxes and insurance made by banks on behalf of homeowners runs into the tens of billions of dollars every month.

Under the CARES Act, Congress has invited millions of Americans to stop paying their mortgages. The impact of this massive unfunded mandate is that the U.S. financial system is headed for a potential default when the cash flow expected from millions of Americans does not arrive.

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Bear in mind that these same Americans will stop making payments on car loans, credit cards and other obligations at the same time that they stop paying the mortgage.

The Trump administration has been slow to fashion a solution for dealing with the cash shortfall that will hit the U.S. financial system in about 30-45 days.

The mortgage industry, including banks, nonbank lenders and servicers, and the government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, will be able to make required payments on $7.7 trillion in mortgage-backed securities in April. But by May, the system will run out of cash and neither the banks, the nonbanks or the GSEs will be able to pay the holders of mortgage bonds – bonds, by the way, which are guaranteed by the U.S. Treasury.

Congress has invited millions of Americans to stop paying their mortgages. The impact of this massive unfunded mandate is that the U.S. financial system is headed for a potential default when the cash flow expected from millions of Americans does not arrive. 

If the issuers in the $2.2 trillion government loan market or the $5.5 trillion conventional loan market fail to make the bond payments to investors, then the Treasury must step in to honor the guarantee.

In the government market, the issuer will notify Ginnie Mae of the shortfall and ask the Treasury to honor its guarantee.

In the conventional market, the issuer will notify the GSEs of a shortfall and the GSEs will need to request funds from the Treasury.  Either way, all roads in this increasingly dangerous situation end with Treasury Secretary Steven Mnuchin.

While Ginnie Mae has begun to fashion a temporary solution to fund the payment arrears in the government market, it is unlikely to be sufficient given the likely size of the loan payment shortfalls that are building each and every day. Hundreds of thousands of borrowers are seeking loan forbearance daily from banks and nonbank lenders.

The accumulated defaults on payments of interest and principal are forming a financial tsunami that could ultimately force a US debt default unless steps are taken now to prepare for this peak in loan forbearance.

Just as U.S. medical professionals must judge the rate of infection from COVID-19 and try to discern when the cases will peak, so too the U.S. financial system is facing a peak of loan defaults that must also be anticipated and managed.

In particular, Secretary Mnuchin needs to quickly fashion a consensus among federal regulators to support the cash needs of the housing finance industry in a way that will honor payments to mortgage bond investors while also giving loan servicers the resources to deal with millions of troubled borrowers.

Specifically, the Treasury needs to work with the Federal Reserve to fashion a liquidity facility for government lenders and servicers. While Ginnie Mae says that it wants to reimburse missed loan payments on a case-by-case basis, this approach will very quickly be shown to be inadequate to the task.

In the larger conventional market, the Treasury needs to take control over the GSEs and use their balance sheets to provide advances to fund missed payments on agency securities.

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One big obstacle facing the Trump administration in fashioning a workable solution to fund missed mortgage payments is Federal Housing Finance Agency head Mark Calabria.  Recently, the GSEs Fannie Mae and Freddie Mac had a liquidity facility ready to put in place to support conventional issuers.

Meetings were scheduled with members of Congress to discuss the plan. Then, suddenly and without any explanation, Calabria ordered the GSEs to stand down and shelve plans to support the industry. To say that people in and around the housing industry were flabbergasted is an understatement.

Following Calabria’s action to shut down the servicer liquidity facility planned by the GSEs, the Financial Stability Oversight Council or “FSOC” met and decided to take a “wait and see” approach to providing liquidity to mortgage servicers, banks and nonbanks alike. The FSOC’s decision was largely taken because of erroneous advice from Director Calabria, who has never actually worked in finance much less in the housing industry. The FSOC and Director Calabria are playing with fire.

The White House, Treasury and Federal Reserve need to put aside Director Calabria’s flawed advice and announce a "solution" to the liquidity issue for agency residential mortgages this week.

We then have a couple of weeks to work out the details, which in simple terms involves the bank and nonbank servicers running an overdraft secured by the mortgages and financed by the Fed.

If a solution is not put in place quickly, then the U.S. Treasury faces the unseemly prospect of financing the payments to agency and Ginnie Mae bond holders in extremis.

The U.S. will be on the edge of the precipice and within just days of a sovereign default.

Anybody who thinks that the market for U.S. Treasury securities can survive the collapse of the agency and government-insured mortgage markets should think again.

Christopher Whalen is Chairman of Whalen Global Advisors LLC in New York.  He is a contributing editor to National Mortgage News and publishes The Institutional Risk Analyst blog.

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