Critical Point Episode 26: COVID-19 and the mortgage credit risk market

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Chris Harner: Hello and welcome to "Critical Point," a podcast brought to you by Milliman. I'm Chris Harner, Managing Director of Milliman's Cyber Risk Solutions group and I'll be your host today. For this episode of "Critical Point" I'm sitting down with Mike Schmitz. He's a principal and consulting actuary with Milliman's mortgage practice. We'll be discussing mortgage credit risk and market trends in light of the COVID-19 pandemic. This episode is the first in a two-part series on credit risk where the next episode will look at the potential for cyberattacks to increase in the financial sector as a result of Coronavirus. Mike, thanks for joining me.

Mike Schmitz: Thanks for having me, Chris.

Chris Harner: Mike, your practice focuses on credit risks arising from lending activity, asset portfolios, that type of thing. And I know you do a lot of analytics. Probably roughly around March when COVID hit the U.S., what type of phone calls were you getting? What were your clients saying? What were the kind of analysis or the fears, the concerns they had since of course you know mortgages and credit is so fundamental to the U.S. economy?

Mike Schmitz: Yeah. We absolutely got a tremendous interest in our services from existing and new clients. Those clients, you know, across the globe are participating in credit in some manner. They could be government guarantors. We work with the FHA and other government loan guarantors. Private guarantors including mortgage guarantee insurers and the global reinsurance market and capital markets participants that are taking credit risk transfer. And it includes banks, lenders, investors in the capital markets, asset managers that have loans or structured credit risks in their portfolios. And all of them were asking essentially the same question which is what are the ramifications of this pandemic and the resulting economic scenarios that it may lead to on the credit positions that they have.

Chris Harner: Yeah, so it feels like this type of event was not anticipated by this space. Is that correct?

Mike Schmitz: Well, you know, I think that pandemics in general have received some attention. And so, you know, where the credit markets particularly focused on a pandemic, you know, if I look back to some of the stress testing that some of my bank clients go through, they've included, you know, pandemic-related stresses. But the big challenge I think is that a pandemic such as COVID-19 is difficult to understand in terms of its full ramifications and the economic consequences of it in today's sort of global travel and interconnected world. And so even though pandemics in general receive some attention, I think that, you know, the COVID-19 scenario is still a new scenario that everybody is trying to understand.

Chris Harner: Yeah, I agree. it feels like, you know, there's so many implications that still have to be thought through. You know, when COVID-19 hit the U.S. a few months ago frankly, you know, personally I had some bad memories of 2007 and '08. I was on Wall Street at the time. My employer took one of the largest bailouts in U.S. history. And I was in Risk Management. And looking back, you know, frankly, everybody was caught off guard. You know, people were running around saying, "Well, no one could have seen this coming." You know, everybody had this kind of exposure to the market. And personally, I love the book and the movie, "The Big Short." It really spoke to me because it helped explain what happened back then. But you know, I was pleasantly surprised when I joined Milliman to learn that you were actually one of the few voices out there that did see that crisis coming. Do you mind just taking a few minutes to tell us about your article, "What Happens When Credit Risks Come Home to Roost?" And when I look at the timestamp, that was published November 1, 2006.

Mike Schmitz: Yeah, thanks, Chris. You know, clearly, the characters depicted in "The Big Short" could see the credit crisis and the global financial crisis evolving in front of them and indeed, you know, the paper that I co-authored with a colleague in 2006 was also forecasting the stress in the residential mortgage market.

In our paper, our thesis was relatively simple. It was that loose underwriting of residential mortgages coupled with home prices that had gotten extremely high relative to fundamental measurements of value such as income and rents could spell the perfect storm that, you know, we believed was going to result in significant stress in the residential mortgage space in the broader economy. So what we saw were that highly leveraged borrowers with low credit scores were getting loans in a prevalence of loan products that were very risky themselves through no documentation of income, assets and employment, interest only features. So these loose underwriting standards were actually fueling that home price graph to go off the charts and out of balance with fundamental measures and so that feedback mechanism was causing a bubble. And so the global financial crisis spilled out of that and you know, I think that there were signs in advance that were clear enough that we published that public paper on it in 2006 in advance of the crisis. But, you know, certainly the consequences of global financial crisis were difficult to predict but we did see that there was a storm brewing and it was squarely focused right on residential mortgage credit.

Chris Harner: Yeah, so it's interesting, Mike, you know, it's all about risk management is that the triggers, you know, there seems to be crisis after crisis and the triggers are always different so we have to stay on our toes. And you know, another favorite book of mine which I actually read just before the financial crisis back in as it started in 2007, was Nassim Taleb's "Black Swan." And you know, when this COVID thing hit I revisited that book and I completely missed it when I had originally read it. But he actually states in the book that there's an increased risk of pandemics due to global travel patterns. And, you know, as it pertains to credit markets, many people feel that COVID-19 fits this definition of, like, this unanticipated extreme tail event with severe consequences. But when we chatted you disagreed. Why?

Mike Schmitz: So much like our article and the characters in "The Big Short" seeing the global financial crisis evolving before it was even happening, Taleb mentions the severe risk of pandemic, particularly when we're in this global interconnected world with travel so prevalent. And then, you know, we've seen SARS and H1N1 and if you go all the way back to the Spanish Flu in 1918, you know, pandemics happen. So in terms of, you know, was it unexpected and therefore a black swan I think, you know, you could easily challenge whether it meets that criteria since Taleb was warning about it, the World Health Organization, you know, as recently as a couple years ago was warning about the risk of a pandemic and Bill Gates has also been warning about those risks of a pandemic. So I do believe that much like the global financial crisis, one could challenge whether COVID-19 would fit the criteria of a black swan.

Chris Harner: You know, one other thing that really people will fixate on for obvious reasons is this concern about mass unemployment. I've seen, you know, dire predictions and articles, talking about mortgage default rates say hitting 30%, that would be worse than the Great Depression. I think that's on a lot of people's minds. What trends are you seeing in the mortgage market since you're analyzing this every day?

Mike Schmitz: Yeah, we're not seeing anything so severe as what you're portraying. And I think that there's many reasons for that, right. We aren't expecting defaults to look like the Great Depression or even the global financial crisis. And I guess there's three main reasons for that. The first reason is that the mortgage market looks completely different than it did going into the global financial crisis. Indeed, the global financial crisis was squarely caused by risks that had built up in the residential mortgage space. Those loose underwriting criteria that sort of defined and gave rise to the global financial crisis, the lessons were learned and underwriting standards are so much tighter these days that the credit quality is just monumentally different than it was going into the global financial crisis. Another reason that we're not expecting that is that there's been unprecedented assistance to borrowers in terms of increased unemployment benefits, helicopter cash, forbearance and other loan assistance programs. So we really are not expecting to see, you know, the type of default rates that came out of the global financial crisis.

The third reason is that U.S. residential mortgage is much more sensitive to home prices than unemployment rates and home prices are actually holding up strongly and are not expected to decline by a substantial amount as a result of COVID-19.

 

Chris Harner: Yeah, that last point's interesting to me because, you know, I live in an area that's kind of semi-rural roughly an hour outside of New York. And it seems like there's still a strong bid out here. I think we talked about, you know, with the pandemic if you have to shelter in place, are we seeing an uptick in certain areas or certain type of buyers of people who want, you know, a home to stay in or if they're in a large urban area to get out if there's this kind of situation?

Mike Schmitz: I think what you're seeing is that there's a lot of focus on your home or your apartment or your condo, that's one of your most important assets when you're in the middle of a pandemic and you're sheltering at home. So there's a lot of attention on trying to keep people in their residences. And that, and you're seeing that bear out in the statistics.

Forbearance take-up rates have not been nearly as high as I think a lot of market participants expected. Forbearance is the ability to not pay your mortgage. So you're effectively suspending the obligation to pay the mortgage payment. And servicers by the CARES Act must allow up to 12 months of forbearance. And even borrowers that are taking a forbearance option, a substantial percentage of those borrowers are actually still paying their mortgage. So whether that's because they want the forbearance as an option if things get worse or whether that's because they have the financial means to make their mortgage payment and they'd rather not get behind but they're still qualified for a forbearance. Even if you look at the rental market, those that are renting are continuing to pay their rent at a comparable level to the 2019 early months. So if you compare March and April of 2020 to March and April of 2019, you see comparable rates with which rents are being paid.

Chris Harner: Yeah, so that's interesting because, you know, something that we saw in the last crisis that was kind of unexpected that makes sense, we had never seen in that people send the keys back to the bank kind of walking away. So it's interesting we're not seeing that. There's actually a strong incentive for is it correct to say both parties to make this work?

Mike Schmitz: Well, what I would say is that after the global financial crisis and home prices going down, it's absolutely the case that borrowers had negative equity, meaning their house was a liability. It wasn't an asset. They had no incentive to pay their mortgage when they could walk away essentially. And so you had a lot of strategic defaults. In this pandemic, your home, your living quarters are a very important asset that you are going to make every effort to hold on to. So whether that means taking advantage of these borrower assistance programs or whether it means, you know, paying your mortgage even though, you know, things are tight and you have to choose which payments you make. We are not seeing the spike in defaults and delinquencies that many market participants expected, particularly in light of the unemployment shocks that we're seeing.

Chris Harner: Yeah, I'm glad you mentioned unemployment. So I wanted to return. You know, I think I almost fell out of my seat when I saw the print on the unemployment numbers dropping from 14.7% to 13.3%. What do you make of that? You know, and what is the implication for the mortgage market?

Mike Schmitz: Yeah, I think the market was generally bracing for that 14.7% unemployment rate to rise further before coming down. But what I would make out of it is that the snapback is actually pretty sharp and maybe faster than market participants were expecting. And you know, there's the potential for a second dip and the potential for a second wave of COVID-19, the return of the economy has been faster as it relates to employment than many market participants were thinking. With that said, as I mentioned, when you are focusing on United States residential mortgages, they're much more correlated to home prices than unemployment. And there's a number of reasons for that. I think what you've seen is both the pandemic and the unemployment shock have disproportionately impacted lower wage groups such as service and retail workers who are disproportionally renters and in the rental market and so it may have less of an impact on the residential mortgage market. But I think that's why borrower assistance is so important and the unemployment benefits are so important. Assistance in general is just really critical because of both the health and humanitarian and economic turmoil that's disproportionately hitting lower income individuals. Also disproportionately hitting black, Hispanic and Asian borrowers. And so it's critically important that those assistance programs help keep those individuals on their feet.

Chris Harner: How significant today is that to the general mortgage book when we think of the largest institutions?

Mike Schmitz: Well, I think in the global financial crisis you saw a very large subprime mortgage market that was fueled by private label securities. While there are private label securities these days, they represent a much smaller percentage of the overall mortgage market. And so you're correct that the non-qualified mortgage world is experiencing worse stress than FHA borrowers and more stress than Fannie and Freddie borrowers. That market is generally very small compared to the broader mortgage market these days.

Chris Harner: We're coming out of shelter in place but it's been pretty rough for retail for businesses that require high traffic. How do we think about commercial lending and again, is there any relationship you're seeing with the “resi” side?

Mike Schmitz: Yeah. I think the stress is definitely cutting across various sectors very differently. Even within consumer you're seeing a much bigger impact on subprime auto, for example, than you are seeing for residential mortgage because unemployment has a much bigger effect on the subprime auto lending. And again, when you're sheltering in place your home is a much more valuable asset than your car is that may get repossessed.

But then also within commercial it cuts very differently across various segments, across various geographic regions that are more focused and oriented towards travel economies such as Nevada. You're seeing it affect different types of industry groups because obviously travel and retail have been hit very substantially by the pandemic and the resulting shutdowns. So you definitely see things cutting across different sectors to different degrees. Now, you know, certainly it's the case that the more severe scenarios get the more correlated the various geographic regions, the more correlated the various industry groups and the more correlated the various asset classes become. But as we look at things as they stand today in the current forecasts, there are very disparate scenarios being painted for those various groups.

Chris Harner: So I know we don't have a crystal ball but, there's talk about a second wave. What are some things we should think of? What should we look at? You know, how are you thinking about that and are any of your clients asking that kind of question?

Mike Schmitz: Yeah, it's very much on the minds of us and our clients. I think that what you're seeing right now is that a second wave is really built into the economic forecasts that we use in our credit models. So if you look at the unemployment scenarios, they definitely show evidence of a second wave to the pandemic. That said, the unemployment scenario that we're seeing is more optimistic than many of those models were built off of. Nevertheless, the scenarios that we're using in our models do show a second wave. Now if the second wave is much larger than is contemplated in those scenarios or the assistance that comes from the government for borrowers and general assistance isn't commensurate with the size of the second wave, then things could undoubtedly get worse. But we are definitely contemplating a second wave to a degree in the forecasts that we're doing because the economic scenarios reflect a second spike to unemployment.

Chris Harner: That's very interesting. You know, after the previous crisis, you know, I left Wall Street in 2009. I got into consulting and you probably remember the Joint Consent Order between the Federal Reserve and the FDIC with the 14 largest mortgage servicers so I got a lot of experience helping do remediation and kind of one of the big themes from that was loan mod, you know, looking at defaults, REO. You know, we talked about forbearance. And again, I can't resist asking, you know, what should we expect? Because, you know, at least last time that was a big theme and again if we go into a second wave, who knows how this plays out. But I would love to hear your thoughts on that.

Mike Schmitz: Yeah. We're spending quite a bit of time on the phone with clients and working on the impacts of the various borrower assistance programs that are out there. We had a practice run on this during the global financial crisis. But this is a very different crisis.

So what you're seeing is that the opportunity to offer forbearance has been, has seen activity but it hasn't been as heavy as I think market participants expected. If you look at the various channels, the overall forbearance take-up rate as we sit here today is about 8.5%, so considerably lower than the unemployment rate. And, as I mentioned earlier, a substantial percentage of those borrowers that are taking advantage of forbearance are nevertheless making their mortgage payments. So it ends up being a very interesting exercise to try to forecast what impact the opportunity to take advantage of forbearance is going to have on ultimate loan performance and that's what we're spending quite a bit of time doing right now. The opportunity to take advantage of 12 months of forbearance means that this could play out over the next 12 months and, you know, we'll see to varying degrees how many borrowers both take advantage of it and how long they take advantage of it. That rate of 8.5% overall is disproportionately influenced by the FHA and Ginnie Mae borrowers and that forbearance rate is about 12%, so it is a bigger chunk of the FHA portfolio whereas the Fannie and Freddie portfolios it's more like 6.4%. You know, I think much as you had strategic defaults in the global financial crisis, I think we might be seeing some strategic forbearance where borrowers that actually have the ability to pay their mortgages are nevertheless taking advantage of forbearance because they can accumulate cash reserves and that they fully expect and plan to make mortgage payments once they have to make mortgage payments.

Office sector workers were very nimbly able to migrate from an office-working environment to a work from home environment. That's what you and I are doing right now and we've seen that across the office sector. And while that's been a huge resilient factor in how our economy has reacted to the pandemic, it does make me wonder what impact migrating all of that technology to a remote working environment might have for the market that you deal with which is quantifying cyber risks and I'd be very interested to get your thoughts on that.

Chris Harner: Yeah, thanks, Mike. You know, it's interesting, you know, working with our clients, people had their BCP plans in place, their Business Continuity Plans; since 9/11 when people put a lot of thought into that, there's been a lot of migration to the cloud. So overall, I think in that, you know, office sector part of the economy the transition wasn't that difficult and particularly in the finance sector. That being said, kind of one of the big themes we're seeing is that, you know, there's this heightened national vulnerability. You know, more or less everybody is working from home because of shelter in place. You know, you still have e-commerce. In particular, you know, ordering things from the pharmacy are pretty important. We've got online schooling going on. And so things are more dependent on the internet than ever before as well as communications. So the cyber implications of that, we will have to address in our next podcast. With that, thank you for your time, Mike. You've been listening to "Critical Point," presented by Milliman. To listen to other episodes of our podcast, visit us at milliman.com or you can find us in iTunes, Google Play, Spotify or Stitcher. See you next time.