This outlook was written in early 2021, as mortgage note investors waited to see how the coronavirus crisis would unfold. Refinancing and new mortgage originations were at record highs, while mortgage defaults and unemployment kept climbing. It was a volatile, somewhat confusing time to be a note investor.
Some note investors believed we were on the brink of another mortgage and real estate collapse; others took a more positive view. In reality, it could have gone either way. Here are the five things the author believed note investors needed to know at the time. They’re also a useful checklist for reading any future downturn.
Government policy will shape the outcome
In late spring 2020, the government authorized unlimited quantitative easing to ease liquidity concerns in the secondary mortgage and bond markets. It also authorized the government-sponsored entities (GSEs), Fannie Mae and Freddie Mac, to buy loans in forbearance. That kept many lenders and servicing companies from going under: as of early December 2020, 5.54% of all servicers’ portfolios were in some stage of forbearance.
Mortgage moratoriums had also protected borrowers in default, but carrying a loan that isn’t paying isn’t sustainable. Eventually, banks and servicers have to foreclose where they can, or sell off nonperforming debt to stay afloat.
The incoming Biden administration had advocated more support for distressed homeowners and financial institutions, through more funding and new protections. The FHFA had extended the foreclosure moratorium and forbearance options to February 28, 2021. Until the new policies were clear, the author expected large sell-offs, especially of nonperforming loans, around mid-summer to fall of that year.
Prepare for tighter regulation
Investors should expect new protections for borrowers who fell behind because of a crisis like COVID-19. Document all communication and loss mitigation efforts carefully, because foreclosures from such a period are likely to end up in litigation.
The Consumer Financial Protection Bureau (CFPB) had just released new debt collection rules, which made proper servicing and loan compliance more important than ever.
Better-quality defaulted loans mean higher prices, to a point
About 2.2 million residential borrowers were seriously delinquent as of November 2020, yet the quality of defaulted mortgages was better than ever. Higher home values meant more homeowners had equity, so a borrower facing foreclosure could sell and pay off the balance.
Combined with generally stronger underwriting over the previous decade, this meant delinquent loans were much better quality than those in default during the previous crisis, and pricing reflected that.
With quantitative easing in place and the option to sell and package loans to the GSEs, there was little pressure to sell at a steep discount. But the longer high unemployment, high default rates and foreclosure moratoriums lasted, the greater the need to sell would become. If investors and servicers can’t foreclose, sellers have to discount for the added regulatory restrictions.
Commercial nonperforming notes may hit the market first
Real estate investors and the commercial mortgage market received very little assistance, even though many sectors were hit hard. According to a Mortgage Bankers Association (MBA) commercial mortgage survey from September 2020, 10.9% of all commercial mortgages were in some stage of delinquency, with retail and lodging the largest share.
Experts expected a large number of distressed commercial sales, including nonperforming loans, over the following few years, as more investors struggled to meet their debt obligations.
Watch for a market correction
Supply and demand were seriously out of balance, putting the market at risk of a major correction. Record-low mortgage rates and low inventory had pushed home prices to new highs.
Because the CARES Act prohibited servicers from reporting a loan as delinquent if the borrower had requested forbearance, the author believed the crisis was far bigger than the numbers showed. Once foreclosures resumed at normal levels, a flood of properties could hit the market, sold to avoid foreclosure or as a result of it, and much of the recent appreciation could disappear. Values were unlikely to fall as far as in the previous crisis, but investors should be prepared for a pullback in prices.
Get liquid and tighten your portfolio
I personally believe big opportunities are coming for note investors, but it’s too early to tell when or to what extent. I’m preparing for a new wave of inventory by getting liquid and tightening up my current portfolio of notes.
Knowing the extent of regulation and the state of the housing market will help me assess my risk and price investment opportunities accordingly.
