A Q&A on the risk of surging Ginnie Mae delinquencies

| March 20, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Ginnie Mae MBS face the prospect of a sharp surge in delinquencies as the coronavirus brings the economy to a sudden halt. Rising unemployment could mean many borrowers will be unable to make mortgage payments.  FHA borrowers are especially at-risk, since many of these borrowers likely work in high face-to-face businesses and cannot easily transition to remote work arrangements. Furthermore, most FHA borrowers have limited assets that could be used to make mortgage payments in the event of unemployment. Surging delinquencies would put severe strain on the FHA and VA and on their mortgage servicers.

The government is taking rapid action to protect borrowers. The FHA has already suspended foreclosures and evictions for 60 days and is likely to leverage existing programs that assist borrowers in the event of hardship or natural disasters. It sounds likely that the FHA will require little-to-no proof of hardship when offering payment forbearance in order to streamline the process for servicers. There is significant concern that servicers will face a massive number of requests for relief and have difficulty processing them in a timely manner. Creating a “streamline forbearance” process will ease the burden.

For the MBS investor, the paramount concern is prepayment speeds. Principal and interest payments are backed by the full faith and credit of the US government, but high delinquency rates could drive higher prepayment speeds when these loans are bought out of pools. Since the crisis is expected to be severe but short, Ginnie Mae is likely to treat it similarly to a natural disaster. In those scenarios Ginnie Mae’s efforts center on minimizing the disruption to all involved parties—borrowers, investors, and servicers—which could keep prepayment speeds tame during this turbulent event.

Q: How fast could Ginnie Mae borrowers default?

Our chief economist, Stephen Stanley, thinks US unemployment will rise from the most recently reported 3.5% in February to 5.5% in the next few months, with other economists projecting higher rates. FHA borrowers and, to a lesser extent, VA borrowers could see an even faster rise. Based on experience from the 2008 crisis, unemployment of 5% could drive up Ginnie Mae serious delinquencies significantly from 2.2% currently to 5.7% (Exhibit 1). If unemployment hits 10%, Ginnie Mae delinquencies could hit a 16.7%. At 15% unemployment, projected delinquencies hit 26.4%. And at 20% unemployment, delinquencies could reach 35.0%. A surge of this type would put a tremendous strain on the FHA and VA, servicers and other parts of the system.

Exhibit 1: Estimated CPR increase under various unemployment rate scenarios

Source: Amherst Pierpont Securities

Likely delinquency rates also imply potential increases in prepayment speeds based on levels of unemployment. Although it is important to note that the FHA and Ginnie Mae might be able to influence the cure rate, especially if the crisis is short-lived, and substantially lower the buyout rate.

These default and prepayment projections reflect the aftermath of 2008. Year-over-year unemployment rose steadily to an October 2009 peak of 10%, and the pace of delinquencies rose right along with it (Exhibit 2). It is also apparent that transition rates fell much more slowly than they increased, taking 4 years to return to a baseline level even though the unemployment rate was slowly falling for much of that time.

Exhibit 2: Increasing unemployment pushes more borrowers to default

Note: The data shows a correlation between the monthly rate at which borrowers become delinquent and the year-over-year increase in the unemployment rate. A simple regression on the data before 2010 suggests a base monthly transition rate of 0.5% (5.8% annualized) and that a 5% increase in the unemployment rate would push the transition rate to 1.0% (11.4%). The exhibit uses the net transition rate, which accounts for the fact that many Ginnie Mae borrowers naturally cure. Any increase in the net transition rate would ultimately become a buyout and push prepayment speeds faster. Source: Ginnie Mae, eMBS, US Bureau of Labor Statistics, Bloomberg, Amherst Pierpont Securities

What’s the link between defaults and prepayments?

Ginnie Mae servicers have the option to buy a loan out of an MBS pool under certain circumstances. Loans must be at least 90 days delinquent, and buyouts are mandatory if a loan is modified or if it defaults. Otherwise the servicer can decide whether the buyout is in their best interest.

A servicer with adequate funds can buy out a loan if the cost of funding is cheaper than advancing principal and interest to the pool. A premium loan would typically be bought out while a discount loan would be left in the pool. This can create a steep buyout S-curve. But a servicer without much liquidity is much more likely to leave a loan in the pool for as long as possible since it is difficult for them to fund the loan after buyout.

Do Ginnie Mae servicers have enough funds to handle a surge in defaults?

Ginnie Mae servicers must advance principal and interest for all defaulted loans in a pool or be held in default by Ginnie Mae. This would result in Ginnie Mae taking control of the MSR and prohibiting that lender (if they are an originator) from pooling any more loans. Ginnie Mae, under the authority of their guaranty, would advance principal and interest on the defaulted loans in that servicer’s portfolio.

However, in the event of a natural disaster Ginnie Mae has the tools to provide relief to servicers that are struggling with a temporary liquidity crunch. Ginnie Mae took advantage of these programs after Hurricanes Harvey, Irma, and Maria in 2017. They took two actions:

  • Ginnie Mae allowed servicers to exceed their delinquency caps. Normally Ginnie Mae does not permit an individual servicer to leave too many delinquent loans in pools and can consider a servicer that does so to be in default.
  • Ginnie Mae used their guaranty authority to advance payments on behalf of especially hard hit servicers. For example, Hurricane Maria hit Puerto Rico especially hard, and some servicers have almost their entire book of business in that territory. They could ask Ginnie Mae to advance funds and have up to 90 days to pay them back (and Ginnie Mae could extend that timeline at their discretion).

The result was that most loans that became delinquent in Puerto Rico remained in pools and cured naturally. Ginnie Mae MBS significantly outperformed conventional MBS after this episode (Exhibit 3). This outcome benefitted borrowers, investors, servicers, and Ginnie Mae.

Exhibit 3: Ginnie Mae Puerto Rico loans prepaid well after Hurricane Maria

Source: Ginnie Mae, eMBS, Amherst Pierpont Securities

It is likely that Ginnie Mae will attempt to follow the same playbook. The coronavirus is comparable to a natural disaster, albeit with likely much greater scale than any prior natural disasters. Social distancing is expected to severely disrupt the economy but for a relatively short period of time. Ginnie Mae will have to make advances if a servicer cannot, but likely faces far fewer operational issues if the existing servicer remains in business and has the chance to recover.

Ginnie Mae also does not want this crisis to damage the mortgage origination process. Many servicers also originate loans, and if they are considered in default they will no longer be able to pool loans in Ginnie Mae MBS. This could remove a significant amount of origination capacity from the market, raising costs to borrowers and possibly hurting home prices after the crisis abates.

 Will the foreclosure and eviction suspension increase speeds?

The foreclosure and eviction suspension should not by itself increase prepayment speeds. Many loans are bought out prior to foreclosure, so this suspension likely has little effect. Consider a loan that is in a pool and about to be foreclosed on.  The buyout would be mandatory, but the suspension could avert that prepayment—the servicer could still opt to do the buyout, but it would no longer be required.

What about VA borrowers?

VA borrowers are typically better credit than FHA borrowers. The severity of this crisis will certainly affect all borrowers, but on average VA borrowers are likely better prepared to weather the crisis. Also, some VA borrowers are active servicemembers and they won’t lose their jobs and miss paychecks, which means the VA sector might do even better in this crisis.

john.killian@santander.us 1 (646) 776-7714

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