How COVID-19 could Impact Note Investors

To say that COVID-19 has affected our country is an understatement. In a matter of days, our country came to a grinding halt. As of April 23rd, 26.5 million jobs have been lost in the US since the pandemic was declared. Combined with pre-Coronavirus unemployment data, the US real unemployment rate has reached 20.6%, a number we have not seen since the Great Depression

Currently, many note investors are discussing the possible flood of defaulted debt that an economic shock might cause as if it’s already a fact. While the real estate and financial industry are currently taking a huge hit, no two financial crises are the same. No one truly knows how note investors will be affected by COVID-19 or what opportunities will be presented moving forward.

But we can make reasoned predictions and plan accordingly.

What I’m Watching

Things are changing daily. So while we are analyzing what happened yesterday, the federal government is drafting legislation to prop up new sections of the economy tomorrow that could completely change the trajectory of the entire economy. 

For this reason, I’m carefully watching several factors that would directly impact note investors and the financial industry:

  1. Loan quality and borrower health
  2. Bank liquidity
  3. Delinquency rates
  4. Government intervention
  5. Real estate prices and sales
  6. Longevity of the crisis and shutdown

Loan quality and borrower health

Many investors are predicting a repeat of the 2008 financial crisis when banks closed at alarming rates and millions of dollars of non-performing debt was sold at steep discounts on the secondary mortgage market — and that very well could happen again. With that in mind, it’s important to consider the quality of the loans today and how they compare to loans created just prior to the Great Recession.

Many of the loans created prior to the Great Recession were considered “high risk” loans that had low down payments, adjustable rates (ARM), balloon payments, and/or borrowers with a credit score lower than 660 (“subprime loans”). 

Today, overall loan quality and borrower health are better. Borrowers have more equity in their homes, have higher credit scores, have more in savings, and have a better payment to income ratio (less of their disposable income is spent on their mortgage each month). Plus there are 9.6 million fewer ARMs in existence. Non-prime loans (this decade’s version of “subprime loans” with a 40-point lower minimum score) make up 11% less of all mortgage loans than they did in 2007. 

But the news is not all good. Overall, America is in more debt than ever. The US has $300 billion dollars more in household debt and $1.55 trillion more non-mortgage debt today than in 2008. 

Bank liquidity

Bank liquidity is everything in the financial market. Banks hold cash reserves to help pay certain short-term debt obligations but much of their liquidity relies upon packaging and re-selling bonds and mortgage-backed securities in the secondary markets. When the economy falters, demand for these investments decreases and banks can have a liquidity crunch. 

In response, they could tighten their lending requirements (like we’re seeing happen currently), limit the number of loans they make, or increase interest rates to increase cash flow. If none of these changes help and liquidity gets too low, they will fail. This is precisely what happened in the 2008 financial crisis and very well what could happen again if liquidity levels are not monitored carefully.

PennyMac, the largest buyer outside of Government Sponsored Entities (GSEs), announced that they will not purchase loans in forbearance, and may require a buyback provision from their sellers on any loan that goes into forbearance within 15 days of purchase. If banks are forced to buy back too many loans, it will worsen the strain they are currently under. 

To further ease liquidity concerns, regulators have reduced the number of months servicers would be required to advance on GSE forbearance loans to only four months.

Mortgage delinquency

Financial institutions and servicing companies that service mortgage-backed securities are required to pay investors even if borrowers stop paying. If the volume of delinquencies meets expectations, this could present a huge problem for the liquidity and health of these institutions as well. Black Knight estimates, “that an unemployment rate of 15%, as projected by Goldman Sachs for Q2 2020, could result in 3.5 million new mortgage delinquencies.” If subsequent forbearance requests reach 20%, servicers would be expected to advance $8.48 billion per month.

Ginnie Mae a federally owned corporation, who guarantees over $2 million loans for servicing companies, has announced that they will help advance qualified loans in forbearance on behalf of the servicer’s. This helps companies who primarily service VA or FHA loans cover borrower payments in forbearance. Additionally, GSEs, Fannie Mae and Freddie Mac, the two largest buyers of mortgage backed securities on the secondary mortgage market, got the green light to purchase loans in forbearance on April 22nd, 2020 — although there are eligibility requirements all forbearance loans they buy must meet.  

Reports from Black Knight and CoreLogic, two of the main providers of mortgage data including monthly reports on the health of the mortgage industry and delinquency rates, will prove to be very informative in the coming months as delinquencies spike around April and May of 2020. Black Knight’s data for March 2020 will be released on May 4, 2020, but their preliminary data shows a 3.3% increase in loan delinquencies, “the first March increase since the turn of the century.” The Mortgage Bankers Association (MBA) found that 5.95% of all loans are in forbearance as of April 20, 2020. 

Government intervention

whPGovernment intervention, by its very nature, has a tremendous effect on our economy. As of the date of this article, the federal government has put the following policies into place:

  • Reduced the Federal funds rate to 0% – 0.25%.
  • Lowered reserve requirements for banks to zero.
  • Announced an unlimited quantitative easing program to purchase bonds and mortgage-backed securities to help with liquidity in the financial markets.
  • Allowed Ginnie Mae, Fannie Mae, and Freddie Mac to buy loans in forbearance or advance payments to investors.
  • Passed the CARES Act, a $2 trillion dollar relief plan that includes a stimulus check to qualified taxpayers up to $2,400, $350 billion for forgivable small business loans through the SBA Payment Protection Program (PPP), and funding for other industries like airlines, large corporations, state and local governments, and the healthcare sector. This act also delays 2019 income tax filings to July 15, 2020. 
  • Approved a second round of funding which included $310 billion added to the Paycheck Protection Program (PPP) when initial relief proved inadequate. 

Additionally, many state and local municipalities have stopped all foreclosure or eviction proceedings indefinitely, including pending foreclosure or tax sales.

More interventions will surely be enacted in the coming weeks. Currently, there are three additional acts being discussed:

  1. The Emergency Money for the People Act would provide $2,000 – $4,000 to qualified individuals who can prove unemployment as a result of COVID-19.
  2. The Rent and Mortgage Cancellation Act would cancel rent and mortgage payments for a year on primary residences only.
  3. The Getting America Back to Work Again Act would introduce a payroll tax that would cover 80% of payroll expenses to incentivize businesses to hire employees.

Real estate prices and sales

While the effect on real estate prices is still unknown, sales will likely be impacted. According to the National Association of Realtor (NAR)’s March 2020 report, existing home sales dropped 8.5% from February 2020 to March 2020.

While some transactions are still taking place, many sellers and buyers are waiting this out. Zillow research compared data from the SARS pandemic and data from China’s COVID-19 lockdowns and expects a 30% – 80% reduction in real estate sales in the coming months. However prior to this crisis, the real estate market was strong. Favorable mortgage rates, low supply, and a seemingly strong economy created buyer confidence and pushed prices higher so the reduction will be buffered a bit.

My predictions for how COVID-19 will impact the note industry

Ultimately, the extent COVID-19 will make on our country depends on the longevity of the shut down. The only thing that is for certain is that the longer this crisis continues, the worse it will get for our economy.

Prediction 1: Our economy will not reopen to mid to late summer

Policy makers are eager to reopen the economy, even when the numbers don’t support it. If things start to “re-open” in May, I believe cases will increase in a second round as it did in Singapore, Taiwan and parts of China and the economy will be forced to stop once again. Assuming our policy marker’s wait until the curve has truly flattened and signs for reopening are supported by facts, I think our country will be impacted by COVID-19 well into early summer months, with things finally starting to truly “return to normal” around August or September.

Prediction 2: More government intervention

The longer this goes, the more the government will intervene. They will do anything to stop things from getting worse, including introducing a $2 trillion stimulus package in the first month of the crisis.

The second round of proposed policies would significantly change everything, including who is hit the hardest (would change from homeowners to investors or landlords), and may alter the need for banks to sell non-performing notes.

Prediction 3: Bank failures and large sell-offs of NPLs will begin late summer

How quickly and how many banks fail will largely depend on the amount of government intervention. However, I do see a need for banks to get rid of unwanted NPLs, especially loans they cannot sell because they are in forbearance.

Prediction 4: Real estate values will decline in overpriced markets

Many markets across the United States have appreciated at incredible rates, far outpacing wage growth. With a waning demand during these uncertain times (or restricted lending), it’s likely some of the overpriced markets will see a decline in real estate values. However, many home values will remain strong. Commercial real estate will be hit the hardest from this pandemic. I believe industrial values will remain, while other sectors like office space, retail, and hospitality (like hotels and vacation rentals) will have a hard time recovering.

Prediction 5: Future policy changes will impact note investors directly

I would not be surprised if major policy changes came out of this crisis as it did after 9/11, ones that may offer certain protections to borrowers affected by COVID-19. While I have no idea what that may look like, I think it’s a very likely possibility.

The note investors that will benefit from this crisis

Large players with deep pockets will be the first to see an increase in inventory and will be the primary benefactors of this crisis. It will take several months, if not years, before we start to see a “trickle down” effect where smaller buyers, those who are purchasing individual notes or small pools at a time are benefiting from this crisis.

If you’re a smaller investor, don’t worry — I do see a need for liquidity in other markets, including home owners who will need to sell the property for cash or private note holders who may be tight on funds or ill prepared for dealing with a delinquent note and will want or need to sell their loan. This could be a great chance to purchase notes or property on a one-off basis or to purchase the real property and create a note while lending restrictions are tightened.

Those with the right connections, the right knowledge, and the capital to fund will be most profitable in the wake of this crisis.

There will be opportunity for every type of investor, but the extent of the opportunity greatly depends on who you are as investor, where you are in your business, and how liquid you are at this time. Now is a great time to become a note investor because of the very likely chance of increased inventory and discounts on notes in the near future. Since this won’t happen for several more months, now is the time to learn and grow your business getting prepared for the opportunity that may come. The predictions above, while based on facts, are still my personal opinions. No one truly knows where the market will go. All of these predictions could happen, or not. If the economy opens back up shortly, the financial markets and economy may be able to overcome this with minimal long term loss or damage. Conduct your own research and always make the best, most informed decision possible for your personal financial situation. We are all affected by COVID-19 in different ways and it is my hope that everyone is safe, well, and in good health.

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