Notwithstanding action taken at every level of government (including emergency measures taken by the Federal Reserve) to attempt to limit the economic fallout of the COVID-19 pandemic, markets remain highly volatile. How loans and structured credit are modeled needs to be modified (and quickly) to reflect the emerging expectations, moral hazard, and risks from the current crisis.
In the consumer finance market, existing models and data for the primary, secondary, and tertiary markets are strong, but these have a high probability of performing poorly as they’re based on historic data that doesn’t reflect the current crisis. To address this issue, RiskSpan has created a top–down framework that incorporates data from select historical events as well as a user-defined view of macro-economic forecasts.
A Framework for Modeling Mortgage Credit in COVID-19
Compile data from past catastrophes
The basis of our approach continues to be data-driven as historic events can serve as data points to inform analysis for the current crisis. Relevant catastrophes to look upon include:
- Natural disasters, including Hurricane Katrina and the impact on regional economies
- The Great Recession and its impact on certain borrowers
- The federal government’s response to the Great Recession
- The Great Depression
- Federal Reserve Board stress tests
These events can inform some part of the modeling framework for key performance drivers, including: 1) unemployment and short-term delinquencies, 2) government relief programs, 3) default and foreclosure, and 4) home price changes and losses to investors.
Unemployment and Mortgage Delinquencies
The impact of unemployment on mortgage delinquencies will be severe. As the graph below shows, the relationship between unemployment and delinquencies is highly correlated—a nearly 1:1 relationship.
We further expect that unemployment and subsequent delinquencies will correlate to regional, state, or business sector unemployment. Certain industries are more susceptible to COVID-19 related disruption stemming from the decline of consumer demand, state and federal orders, and international government actions that affect tourism. Further, state–level executive orders and COVID-19 responses have been inconsistent—some state orders are more severe than others. This will lead to a corresponding impact at the state versus federal level and highlights the importance of taking geo-specific macroeconomic factors into account.
Economic forecasts of unemployment related to the current crisis vary widely so we look to past levels to inform possible boundaries. During the Great Recession, nearly 9 million people lost their jobs within one year leading to an unemployment rate of 10%, according to the BLS. In contrast, new unemployment claims spiked on March 26, 2020, to 3.28 million according to the Labor Department, and then to an astounding 6.6 million today. These figures far exceed the previous high of 665,000 claims during the Great Recession. The Great Depression can also serve as a benchmark when unemployment peaked at 24.9% in 1933. This can be particularly relevant for certain geographies or industries. The Federal Reserve 2020 Severely Adverse Scenario, with unemployment peaking at 10% in 2021, suddenly looks more akin to a base or optimistic scenario.
Government Relief and Delinquencies
The national scope of COVID-19 is forcing governments and mortgage guarantors into nationwide mortgage forbearance, foreclosure moratoriums, and government relief programs. Regardless of type or reason, mortgage non-payment will result in a peak in delinquencies which may remain elevated through a forbearance period.
We can look to natural disasters, like New Orleans and Puerto Rico hurricanes and the Houston floods, to find dramatic and immediate spikes in delinquencies. However, these natural disasters did not result in a corresponding spike in serious mortgages delinquencies or defaults. In these examples, forbearance and moratorium programs provided relief to borrowers until insurance companies paid claims.
Seriously Delinquent and Default
As the table below shows, the Great Recession produced multiyear elevated delinquency and default rates with delinquencies spiking at near 10% in 2010. Peak default rates for some private investor programs exceeded 40%.
However, mortgage defaults from the Great Recession included the impact of aggressively expanded underwriting with rampant and unfettered fraud in the form of subprime and NINA (No Income No Assets) mortgage programs. The historical trend of RiskSpan’s Vintage Quality Index reflects the degree to which underwriting guidelines have generally tightened and steadied over the past decade.
Efforts to reduce default rates during the 2008 financial crisis were further hampered by initially slow government responses and uncoordinated efforts between investors and federal and state agencies. In the current crisis, we can expect government responses to COVID-19 to be immediate, aggressive, and coordinated. The U.S. federal government has already enacted relief legislation, recognizing that forbearance, loan modifications, and moratoriums are all proven tools to reduce mortgage delinquencies and severities. Unlike in 2008, however, the mortgages impacted by the current crisis are primarily federally insured and likely skewed towards low–income and low–FICO borrowers. Because federally insured mortgages tend to find their way into Ginnie Mae MBS, emerging issues relating to advances on those securities may require new and unproven programs.
The residential real estate market was strong prior to the pandemic. Home sales in February rose 6.5% to 5.77 million, according to the National Association of Realtors, and median home prices rose 8.0% year-over-year. As COVID-19 spreads, new sales activity is already coming to a halt, yet the impact on HPA is uncertain. A review of natural disasters, such as the Houston and Louisiana hurricanes, shows little negative long–term impact on HPA after the events. By comparison, the Great Recession produced nationwide declines that did not begin to rebound until 2012 (see below).
Supporting the argument of a short-term impact on HPA are the recent strength of the U.S. economy and continued discipline in credit lending standards. Further, there is also strong generational demand for housing during a nationwide housing shortage. Arguments for a less optimistic view are based on the potential for a longer-than–expected national economic shutdown and structural impacts to the economy, employment, and industries even after the pandemic ends.
The aphorism “things work until they don’t” is commonly used to explain financial markets and behaviors. The COVID-19 crisis is simply the latest manifestation of this reality. Risk managers and finance executives have to decide whether to rely on current models built on historical events and data – the models that got you here – or to start rethinking and retesting hypotheses and assumptions to manage and quantify new risks.