We are not ready for the next housing downturn

The pandemic wrought financial havoc across the economy, but its impact on the housing market was significantly reduced due to a whole-of-government response that enabled millions of families to stay in their homes. The rapid deployment of forbearance, the ability to pause mortgage payments and a slew of new options to modify distressed mortgages provided critical support to households that prevented a deep and lasting housing recession. 

These tools, however, came with a financial cost, which was borne by mortgage servicers who were able to shoulder this burden by virtue of the historic refinance boom that followed the onset of the pandemic. The Federal Reserve’s intervention in the economy materially lowered mortgage rates, which both helped households save on their monthly payments and drove significant refinance activity, which gave mortgage servicers the operating capital to fund the cost of loss mitigation. 

But if we remain in an inflationary environment before the next housing downturn, the Fed may not respond by lowering the cost of credit, so we cannot rely on monetary policy to fund the use of these tools in the near term. We need to start building new vehicles to provide liquidity to servicers so they can help keep borrowers in their homes in the event of a downturn.

The vulnerability of independent mortgage banks

While the economy has proven resilient across the last few years, households are showing increasing signs of stress. At the same time, mortgage lenders, in particular independent mortgage banks (IMBs), have weathered several years of lower mortgage activity due to millions of borrowers being “locked-in” to their current mortgages originated or refinanced during the extremely low-rate pandemic era. 

Unlike traditional banking institutions, IMBs are monoline firms that do not benefit from the diversified business lines that typify traditional banks, so they are reliant on mortgage activity for revenue. 

Significant economic downturns like our pandemic experience and the global financial crisis of 2008 prompted the Federal Reserve to support greater economic activity by lowering the cost of credit; however, downturns and monetary easing do not always coincide, and today’s market reflects an inflationary environment that would likely render the Fed unwilling or unable to bolster the economy through a round of easing. Chairman Warsh’s first rate-setting meeting indicates that fighting inflation remains a priority and the Fed is strongly indicating either a stable or rising interest rate environment unless economic conditions change.

A perfect storm for housing finance

A downturn in the current economic environment would look vastly different than our most recent experiences. Mortgage servicers will not be able to manage a significant number of mortgage delinquencies in a low-origination environment without financing support. To the extent new loss mitigation tools are needed to address borrower distress, they will increase IMBs’ funding challenges, despite being a good investment of resources. 

This environment sets up the housing finance system for a potential “perfect storm,” in which large numbers of borrowers experience distress and default on their mortgages, even as the traditional sources of working capital for lenders become unavailable just when that liquidity is needed most. 

Managing mortgages of borrowers in distress is costly, but research has shown that prompt intervention is a good investment for mortgage servicers as the financial benefit of reperformance is often greater than recoveries in foreclosure. This recovery, however, takes time, and lenders need access to working capital to support borrowers and mitigate their own losses by modifying mortgages so that both they and borrowers can get to a sustainable outcome. 

The systemic risk of servicer failures

The potential failure of multiple mortgage servicers would present unique challenges to the housing finance system and broader economy. The Financial Stability Oversight Council (FSOC) published a report in 2024 laying out the ramifications of such a scenario. 

As the FSOC noted, servicer failures put distressed borrowers at risk of not getting available forms of mortgage relief. While mortgage servicing transfers occur regularly in the ordinary course, transfers related to servicer failures can be chaotic because they must be completed immediately, increasing the risk that borrowers will be lost in the process. 

Servicing failures result in the immediate transfer of servicing responsibilities to Ginnie Mae and the GSEs. Both Ginnie Mae and the GSEs rely on healthy mortgage servicers to take on these responsibilities, but finding new servicers in an environment that has led to the failure of multiple servicers would be challenging and would increase the likelihood that these transfers are delayed or impaired, exacerbating the impact on affected borrowers. Finally, as the FSOC noted, most mortgage servicers are also mortgage originators, so a disorderly set of failures can also threaten the availability and affordability of mortgages for new borrowers. 

How policymakers can prevent a crisis

What has changed in the years since the FSOC released its report is that the theoretical scenario that other experts and I have worried about has become much less theoretical. 

Over the last several years, a number of potential liquidity solutions have been suggested by experts and policymakers, each with its own advantages and drawbacks. The FSOC itself recommended a number of possible solutions, including asking Congress for new authorities to enable the federal government to provide liquidity when private-sector sources fail. 

While it is unlikely that there is a single “silver bullet” approach to solving this liquidity challenge, it is critical that stakeholders and policymakers work together to implement tools that make helping borrowers sustainable, so we can prevent deep and lasting harm to households and the economy before the storm hits. 

Sam Valverde, Managing Director at Falcon Capital Advisors and Former Acting President of Ginnie Mae
This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners. To contact the editor responsible for this piece: [email protected].