Won’t record unemployment lead to massive defaults?

Historically, there’s been a reliable pattern that starts with an economic downturn, followed by rising unemployment, delinquent mortgage payments, defaulted loans and, finally, foreclosures. But COVID-19 disrupted that pattern, stopping a strong economy in its tracks. Unemployment rates went from 50-year lows to record highs virtually overnight, not because of weakness in the economy, but because the government essentially shut the economy down in an effort to limit the spread of the coronavirus. 

The unusual nature of this pandemic-induced unemployment is one of the reasons that the normal pattern may not apply this time. Why? Unemployment hit certain industries much harder than others – travel and tourism, hospitality, retail, restaurants and personal services. These are all industries made up of relatively low-earning, hourly wage employees who tend to be renters, not homeowners. According to the U.S. Census Bureau, the homeownership rate for households making less than the median income is about 50%; for households making more than the median income, the homeownership rate is about 80%. Homeownership rates are also lower for young adults, and adults without a college education, both fairly typical traits of employees within the most impacted industries. 

Research from First American Economics tracked the “unemployment gap” between renters and homeowners. The gap, which had virtually disappeared prior to the pandemic, increases during recessions, where renters are typically harder hit with job loss. The research suggests that the gap will widen even more dramatically this time than it usually does during an economic downturn due to the industries most negatively affected, meaning that homeowners and the pool of potential homeowners probably won’t suffer as much financially as renters will, unless the recession is longer and more severe than expected. 

Up to 85% of the jobless claims made during the pandemic were filed as “temporary” job loss. While it’s unlikely that all of the temporary jobs lost will come back, unemployment claims appear to have peaked. It’s likely that many workers will find themselves back at work sooner than later.

Doesn’t forbearance = foreclosure?

Another argument suggesting that we’re about to see a huge wave of foreclosures is that millions of homeowners have asked for forbearance on their mortgage payments. And there’s no disputing that fact: by mid-June, the percentage of homeowners in forbearance had reached 8.55% – almost 4.3 million borrowers. But a look inside the numbers tells a slightly less desperate story.

The percentage of borrowers in forbearance is dramatically lower than the 25% some experts predicted.

The number of borrowers entering forbearance also appears to have peaked at the very earliest stage of the pandemic. According to the Mortgage Bankers Association, borrower requests for forbearance were highest during the week of March 30 (just prior to April mortgage payments being due), and have been lower every week since. If financial distress among homeowners had been becoming more severe, we should have seen spikes near the first of each month when the next mortgage payment was due; but that wasn’t the case in either May or June, and by mid-June, the MBA reported its first weekly decline in borrowers in the program.

Borrower behavior within the forbearance program has been encouraging. According to reports, over 40% of borrowers made a mortgage payment in April, despite being in forbearance, and 20% did so in May and June.

Finally, the nature of the repayment plans for borrowers in the forbearance program are designed to minimize default. The deferred payments are simply tacked on to the end of the mortgage, and due when the loan is paid in full, refinanced or when the property is sold. 

High demand + low supply + high equity = safer landings

Not all homeowners will escape from an economic downturn as severe as this one. But even for those borrowers who simply won’t be able to resume making mortgage payments due to economic hardship, not all is lost.

Homeowners entered the pandemic with a record level of equity – over $6.5 trillion. Even homeowners in the forbearance program have healthy levels of equity. Black Knight reported this summer that 91% of those borrowers have more than 10% equity in their homes, and equity gives borrowers options that help them avoid foreclosures. Historically, more distressed properties are resolved through a traditional sale than via foreclosure, and it’s likely that this is what will happen again post-COVID-19 (the exception to this rule was during the Great Recession when homeowners had very little equity and the supply of homes for sale exceeded demand). Current conditions in the housing market – extremely limited supply of homes for sale combined with strong demand fueled by historically low mortgage rates – definitely favor this sort of disposition strategy for distressed sellers.

Recent – and distant – history favor a recovery

Market conditions entering the pandemic bore virtually no resemblance to the market leading into the Great Recession. In 2008, the housing market was overbuilt; in 2020, demand is outpacing supply, and analysts believe the market is being underbuilt by several hundred thousand units a year. In 2008, homes were overpriced; in 2020, even as nominal home prices passed their prior peak, the combination of low interest rates and wage growth increased consumers’ homebuying power.

Loan quality was abysmal in 2008, but outstanding in 2020 due to years of responsible (and risk-averse) lending practices by mortgage companies. In fact, both delinquency rates and default rates were running well below their historical averages before the forbearance programs went into effect. 

And historically, housing has tended to fare reasonably well during and after pandemics, recessions, and other economic shocks, such as the terrorist attacks on 9/11. While home sales volume generally dips at the outset of a downturn, prices hold and usually rise as the volume of sales increases. In fact, housing is often an important driver in bringing the U.S. economy back during these recessionary periods.

What could go wrong?

First, let’s be clear: there will definitely be an increase in default activity. To suggest otherwise would be irresponsible and a bit foolish, given the severity of the hit to the U.S. economy. The question isn’t whether default rates will go up, but if they’ll go up as high as they were during the Great Recession, when foreclosure rates peaked at 4% of active mortgages, and delinquency rates approached 12%. Given the factors discussed above, it doesn’t seem likely that we’ll see as much default activity this time as we did in 2008, but we’ll absolutely see more delinquencies and foreclosures than what we’ve seen over the past few years. 

There are also other factors that could drive default activities to much higher levels. For example, if there’s a second wave of the coronavirus more severe than the first one, it could result in an even deeper, and longer-lasting, recession than what’s now being forecast, regardless of whether or not the federal or state governments “officially” implement shelter-in-place or quarantine rules. 

The industry could also make the situation worse. While the forbearance program for government-backed loans has been designed very specifically to help borrowers avoid default, 40% of mortgage loans are in private portfolios, which don’t necessarily have to follow the rules outlined by the FHFA or FHA. If those private lenders do something extraordinarily foolish such as demanding lump-sum payments from their borrowers at the end of the forbearance period, we could also see an immediate (and largely unnecessary) spike in foreclosures. 

This is 2020: the year of the global pandemic, killer hornets, social unrest and what promises to be a rancorous presidential election. It’s hard to bet against another unexpected twist in what’s already been an unprecedented and unpredictable year. 

To read the full August issue of HousingWire Magazine, click here.