March 29, 2020

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Twitter: @joshrosner

GF&Co.: A Corona Crisis & Mortgage Crisis?

When Congress passed the Cares Act, it did so without either fully considering the risks it
created in the housing market or consulting with the firms that would have to implement and step
in on the borrowers’ behalf to advance forborne payments. Specifically, in an effort to support
consumers the Act created an opportunity for millions of borrowers to stop paying their
mortgage loans as long as they claim to have been economically impacted as a direct or indirect
result of the Covid-19 crisis. The Act does not require any proof be furnished, and in fact,
prohibits mortgage servicers from asking for any proof of such an economic hardship. This
forbearance program creates further bifurcation in borrower outcomes as it applies to loans
backed by the Federal Housing Authority Loans and the Government Sponsored Enterprises and
it does not provide forbearance to borrowers whose loans are issued and owned by private
lenders.

The inherent issues of moral hazard and the inequitable treatment of borrowers who received
loans from government-chartered banks from loans received from government backed lending
programs are obvious areas of concern. More importantly, the legislation created several larger
risks that – in combination with Federal Reserve activities - have already threatened the
mortgage industry, the mortgage market, the housing market and, therefore, the broader
economy.

Section 4022 of the Cares Act – Ultimate Moral Hazard, Ultimate Economic Risk
Over the past few weeks it has become clear that the Covid-19 crisis, while being a national
concern, is likely to be a rolling series of regional social and economic crises, each of which can
last a few months. In this regard it may become more like a series of hurricanes hitting different
geographies in succession than a true nationwide emergency.

Nonetheless, Congress included a section in the Act which allows all mortgage borrowers, whose
loans are backed by Government programs to request and receive mortgage forbearance in the
form of skipping payments for up to 180 days and, then if the borrowers want to extend that
‘holiday’ to request forbearance for up to an additional 180 days.

Please refer to important disclosures at the end of this report.

The language in the legislation makes it clear that this forbearance is only intended to apply to
borrowers who are “experiencing a financial hardship due, directly or indirectly, to the COVID–
19 emergency”. Unfortunately, the language does not define an economic hardship and it does
not require borrowers to supply proof of such hardship. In fact, the legislation simply states
forbearance “shall [be granted] with no additional documentation required other than the
borrower’s attestation to a financial hardship”. As a result, without further legislative or
regulatory adjustments this legislation is likely to result in significant servicer failures,
losses at counterparties, material and unnecessary losses at the FHA, further stresses in the
TBA market and negative impacts on home sale volumes and prices.

A Legislative Technical Fix is Required

The language further states that the extension of forbearance to a second 180-day period be
granted as long as the “extension is made during the covered period”. Remarkably, Section
4022 does not include the definition of a ‘covered period’. Although a separate section of the
bill, 4023, defines a covered period, Courts have regularly recognized that laws are to be read on
the plain text written and that it not the prerogative of other branches of Government to read into
inclusions and omissions by Congress. As such, Congress must move swiftly to pass technical
amendment legislation to address Section 4022 to avoid extensions of forbearance well
beyond any economic necessity. After all, the long-term impacts of undermining investor
confidence in government backed mortgage programs are as significant as the moral
hazard of offering large numbers of borrowers easy terms on unnecessary long-term
forbearance .

Failure to Protect All Involved Parties

An even larger problem with Section 4022 exists and it has already created unintended
systemic and fiscal risks to borrowers, to servicers of the loans, to investors in the mortgage-
backed pools, and to the financial position of the government’s mortgage programs that guaranty
these mortgages.

The bill allows any borrower to stop payments as long as they attest to the fact (with no required
proof) that they have suffered some economic harm cause “directly or indirectly” by the Covid-
19 emergency. While this may sound attractive to borrowers it may not be attractive at all
because the Act does not define how they are going to be required to repay their missed
payments. This is critical information for the mortgage servicing market, for the mortgage
backed investor and for owners of mortgage servicing rights. It is also critical information that
MUST be provided to borrowers before they enter into forbearance. One can’t even consider

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such a consumer forbearance program to be an ‘agreement’ without borrowers first
understanding the repayment terms.

Given Congress’ desire that forbearance be available to borrowers who have had an economic
hardship it is reasonable that regulators who oversee these government programs would require
that a loss of income or other economic hardship become the basis of the borrower’s repayment
schedule. The absence of language defining the repayment terms, other than requirements
that it include “no fees, penalties, or interest beyond the amounts scheduled or calculated as if
the borrower made all contractual payments on time and in full” creates an imperative for the
Department of Housing and Urban Development and the Federal Housing Finance Agency
to immediately promulgate interim rules to define the repayment standards and then to
announce those publicly and clearly. Such an announcement will allow borrowers, analysts,
investors, the government and servicers to each assess the demand for, and the ultimate
economic and fiscal costs of, these programs.

As example, if at the end of the (not yet) defined “covered period” a borrower who received
forbearance but cannot establish economic impairment was required to repay all of the
arrears in a lump-sum perhaps then few borrowers who did not really need forbearance would
request forbearance. Conversely, if a borrower who requested forbearance was able to prove,
at the end of the “covered” period that they were economically impaired then the principal and
interest arrears would be added back to the back end of the loan then Congress’ intent would
be satisfied.

Why Does this Matter – Servicer Receivable Advances

By enacting legislation, in the manner in which it did, Congress has pushed an entire industry to
the brink of collapse and the federal regulators seem not to want to let a crisis to go to waste and
risk creating a bigger crisis by offering only a weak handed lifeline.

By their business, non-bank servicers (who service over 60% of FHA and 30% of GSE loans),
are obligated to ensure the collection of timely payments of principal and interest and to forward
those payments to mortgage backed investors. By unilaterally declaring a mortgage payment
holiday, without consultation with or support of the harmed servicers, the Government is
forcing those servicers to advance up to a year of mortgage payments which they are not
collecting from borrowers. It is not even clear that such a statutory demand upon private
parties, without renumeration or consideration, is legal.

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While the harms suffered by these firms is clearly the result of Government action there has been
only feeble and limited effort by regulators to help provide the liquidity to these firms so that
they can continue to originate, refinance and service government-backed loans. Such failure to
act, by the Fed risks being seen as disparate treatment relative to the bank owned servicers who
can pledge collateral at the Federal Reserve and receive ample liquidity to meet these
obligations. Since this is a liquidity and not a solvency issue why has the Fed not set up an
advance facility under its 13.3 authorities? Instead, GNMA has set up a program that appears
too small and perhaps too costly to provide adequate liquidity. Similarly, the Fed’s TALF
program now contains a program that accepts eligible servicing advance receivables but only of
securitized assets and the terms have not yet been set.

A failure to provide a servicer advance receivable facility will not only crush these firms but will
harm consumers who have loan originations in the pipeline, refinancing’s in the pipeline and will
materially increase the risk that, at the end of forbearance, there will be a lack of adequate
servicing capacity. This would result in truly unnecessary increases in defaults and higher
costs of credit to government backed mortgage programs.

As if the lack of a properly sized liquidity facility for servicer advances was not enough, there is
another issue now imperiling the solvency and very existence of some of the largest non-bank
mortgage servicers in the United States. Left unaddressed we could see the failure of some of
these firms this coming week.

Why Does this Matter – Margin Calls on Mortgage Pipelines

When a mortgage originator agrees to make a loan it can do so on a ‘best effort’ or ‘mandatory
delivery’ basis. In a best efforts mortgage lock the seller attempts to make a best-effort to deliver
the mortgage to the buyer and, by doing so, they transfer the risk that a loan will not close to the
secondary market. On the other hand, mortgage originators who hedge their own pipelines
usually enter into mandatory mortgage locks and assume the risk of a loan not closing. Because
they retain the risk these loans generally command better pricing in the secondary market than
best efforts.

Unfortunately, at the time that the Coronavirus became a national economic concern there
was about $400 billion of mortgages in the pipelines of these non-bank servicers. When the
Fed stepped in to buy MBS it, combined with the mass forbearance, whipsawed spreads. On
Friday April 20th FNM 2.5% UMBS TBA closed at 98.5. By Friday April 27th fear had resumed
and they closed at 104. As a result a properly, at the time, hedged book ended up taking a

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negative 6.5% swing. If you multiply that by about $400 billion it is easy to see how these firms
were again hit by the fallout from Government actions. Add to this that the value of mortgage
servicing rights collapsed, after all, who wants to pay for the rights to service loans when it is
unclear if you will ever get paid. The MSR values went about 1.5 to negative 1.5 in a short
period and the dislocations are killing these firms. Where they would typically be able to
recapture that 6.5% swing over the roughly 30 days it takes to close loans, now they are
likely to only recapture about 4.5%.

These government actions have caused these non-bank mortgage servicers to get pummeled
by aggressive margin calls from their banks. By the end of the day Friday we were hearing of
firms that were getting aggregate calls in the billions of dollars. Origination and servicing are
very capital-intensive businesses and operates on high volumes and thin margins. While these
firms were solvent before the Government’s actions that solvency is now at risk as the result of
both liquidity events and margin calls.

So, What’s a Regulator to Do?

Based on conversations we have had over the past several days, with regulators and industry
groups, it seems that the Fed is reluctant to address the non-bank servicer’s problems on a timely
basis. It seems they, and others within the FSOC community, believe that they should ‘instill
some market discipline’ by allowing a few failures to occur before taking actions of the
appropriate scale.

This perspective is the same doctrinaire & academic thinking that led to the disaster that was the
Lehman weekend. Attempts to cull the herd in a macro crisis doesn’t result in appropriate
thinning of the herd instead it threatens the extinction of the entire herd by calling into question
the government’s ability and willingness to act and the prospective insolvency of the entire food-
chain if it fails to act. If regulators are unhappy with the structure of the origination and servicing
industry there is an appropriate time to thin the herd after the crisis, through new liquidity and
capital requirements. Instead by driving failures now, in a crisis, they risk turning a health
crisis into a liquidity crisis, a liquidity crisis into a solvency crisis, a solvency crisis into a
mortgage crisis and a mortgage crisis into a systemic housing and housing price crisis.

In fact, FSOC’s seeming willingness to let a few servicers fail before they step in is eerily similar
to Boris Johnson’s first approach to coronavirus in Britain which went something like:
“Everyone go about your business, sure some will die but the rest will be healthier and the virus

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will burn itself out”. That was a failed approach that both increased and accelerated the spread of
the virus and ended up infecting the leader who made that decision.

So, What Should be Done?

First, it must be accepted that the majority of the market dislocations we have witnessed are the
result of legislation that appears to offer nearly every American with a government-backed
mortgage a year of payment holiday regardless of whether they really need that holiday or not.
The legislation failed to clarify if that forbearance goes away when the President announces an
end to the national emergency. Congress must do a technical fix to add a covered period and
clarify the end of the forbearance ends at the sooner of the end of the emergency or the end
of the forbearance period.

Second, the legislation needs to be fixed so that – before forbearance is granted - a borrower
must submit some form of proof that he/she has suffered a real and meaningful economic harm
due, directly or indirectly, to the coronavirus. This could be as simple as including an
unemployment filing, a termination letter or wage check showing a reduction in pay.

Third, the Cares Act was silent on the structure of repayments at the end of the forbearance
period. To reduce the likelihood of large numbers of borrowers opportunistically seeking
forbearance, without suffering a meaningful impairment in their ability to pay, the relevant
Government agencies (HUD, FHA, FHFA…) should immediately and jointly announce
interim rulemaking that creates a standard of proof that is required to establish proof of
economic hardship. At the end of the forbearance period those borrowers who establish that they
meet the standard of proof will have the missed payments recapitalized in their loan and those
who are unable to establish that they meet the standards of proof of actual economic
impact will be required to repay the arrears in a lump sum within 30-days of the end of the
forbearance period. The public announcement and advertisement of such rules would
reduce the numbers of borrowers seeking forbearance to only those that Congress actually
intended to assist.

If regulators want investors to provide ongoing funding and support to the credit markets those
regulators must assure investors that their assets are secure from seemingly arbitrary actions
that can threaten prepayment speeds and increased defaults. Alternatively, mortgage credit
liquidity may become less available going forward and credit costs will rise.

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Fourth, during the time that these issues are being addressed the Federal Reserve should direct
their regulated banks to cease margin calls on non-bank servicers for pipeline hedges. The Fed
should set production date periods for which they will stand in for these non-bank servicers as
the servicers work down their existing pipelines.

Fifth, until there is clarity about how many borrowers will seek forbearance and clarification
about how repayments will be processed the Fed should create a special facility, under 13.3, to
allow these non-bank mortgage servicers to access liquidity to manage their advances. After all,
these advance requirements are not driven by either market dynamics or irresponsible servicing
but by misguided emergency Government policy.

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