The current market narrative is dominated by three distinct positive themes:
1. Federal Reserve (“Fed”) Stimulus of $120 billion/month
2. Fiscal stimulus of $900 billion delivered in December 2020
3. Rapid vaccination of the population and a return to normal spending
These strong narratives are contributing to a huge bull market in US stocks. However, the looming problem we see ahead for the economy and markets are skyrocketing mortgage delinquencies.
Hello, Titanic, meet your Iceberg: 3Q2020 Mortgage Delinquency Rates.
Source: LIMW Research, Mortgage Bankers Association
One of the features of the 2020 Cares Act was forbearance for renters and mortgage holders. Depending on the state, consumers were given the option to defer payments until a later date, negotiable with the lender or landlord. The latest stimulus bill extended several provisions through the end of February 2021. In the depths of the pandemic shutdown, this was an act of mercy for those thrown out of work with no way to pay for a roof over their heads.
Now, the bill is coming due. It is impossible in our heavily leveraged society to give debt or rental forbearance without causing pain to move up the financial chain to the lender or landlord. After all, the lenders and landlords may themselves be liable for their own property taxes, maintenance, debt and mortgage payments that cannot be deferred. That cash must come from somewhere.
How big are these real estate debt markets? Pretty big. Commercial and Industrial loans are about $2.8 trillion dollars and have nearly doubled since the last peak before the financial crisis. Total Home and Multi-family Residential Mortgages are even larger at $13 trillion, up from $12 trillion before the financial crisis. The following two charts from the St. Louis Fed put these two debt markets in context with their 2Q2020 delinquency rates.
As you can see, there was a little tick up as of 2Q2020 within Residential, but not a disaster. The problem is that the 3Q2020 data from the Mortgage Bankers Association indicates delinquencies are skyrocketing. This is an early sign of the strain on the financial system emanating from the real estate debt markets.
In a normal recession, you would expect the Fed to step in and support distressed markets as a default wave crashes through the economy. However, this recession is far from normal, and the Fed has already delivered trillions of dollars in stimulus before the first delinquency issues even showed up. It is possible the markets will not care about a normal credit cycle because they expect the Fed to step in whenever needed. Historically, the Fed has supported problems in the banking system, but today’s residential mortgages are widely held across financial institutions other than banks. Pension funds, insurance companies, mutual funds, hedge funds and private equity firms have gobbled up these bonds in the search for yield. If delinquencies turn to defaults, the behavior of these non-bank financial institutions will become one of the largest unknowns facing markets in 2021.
Stress is building and the market currently believes the Fed will prevent all bad financial outcomes. Any disruption to this narrative will result in painful selling, especially for the non-bank financials the Fed does not normally bail out during emergencies.
That being said, if the Fed steps in and extends their already expansive emergency powers to bail out these bond holders, then none of this will matter.
Robert Lloyd, CFA® is President and Chief Investment Officer of Lloyds Intrepid Wealth Management, and author of the book CENTRAL MARKETS. Since 1994, he has held positions as a trader, analyst, portfolio manager, and wealth manager while working at Invesco, CCM Opportunistic Advisors, and Merrill Lynch. In another life, he served 8 years in the U.S. Navy as a Naval Flight Officer flying in the S-3B Viking. For a complete resumé, visit his profile at LinkedIn.
Lloyd holds a BBA from the University of Notre Dame and an MBA from the University of Chicago.
Lloyd is a Chartered Financial Analyst.
Lloyds Intrepid LLC is doing business as Lloyds Intrepid Wealth Management. Lloyds Intrepid LLC offers investment advisory services in the State of Texas where registered and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. Lloyds Intrepid LLC and its advisers do not provide legal, tax or accounting advice. Lloyds Intrepid LLC formulates retirement plans, investment strategies, portfolio construction and investment due diligence for clients with signed investment advisory agreements with us. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. All opinions and outlooks are subject to change.
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