This will be our next mortgage crisis
Last month, the Federal Housing Finance Agency released its final capital requirements for the GSEs, attempting to close the chapter on 12 years of conservatorship. Looking ahead, what new mortgage issues could become the next mortgage crisis? My bet: VA “no-bids,” in which a VA loan defaults, the VA only (usually) pays its percentage claim, normally 25% of the loan’s UPB and expenses, and declines its option to acquire the liquidated property. In these cases, servicers are required to absorb all unreimbursed default and foreclosure expenses.
VA “No-bids” have the potential to bankrupt numerous servicers of Veteran’s Administration loans in the near term. Ultimately losses from bankrupt VA servicers would have to be absorbed by Ginnie Mae to protect its MBS guarantee.
The reasons for this are multifold. First, VA’s Certificate of Eligibility guarantee is only first-loss coverage, it does not cover all losses on a defaulted VA loan. Losses in excess of the VA claim payment are covered by the servicer. Ginnie Mae must cover any financial shortfalls if the servicer is unable to cover the losses. As of today, 75% of VA loans are serviced by higher-risk nonbank financial institutions. Finally, VA loans have less MI insurance coverage and collect less revenue, while VA servicers hold almost no capital against this risk exposure in their servicing portfolios.
The VA Loan Guarantee program is not in trouble. Rather, it is the servicers who do not have the financial strength or stability to manage through a severe economic downturn who are in a tough situation.
Ginnie Mae’s exposure on VA loans is much larger than on comparable FHA loans. If the servicer goes into bankruptcy, Ginnie Mae must advance principal and interest on all the servicer’s Ginnie Mae loans, transfer the servicing and provide indemnity to the new servicer.
With servicers in the second-loss position for VA loans, their financial strength and ability to absorb losses is critical. There has been a dramatic shift in the financial institutions servicing these loans. In 2013, banks serviced 70% of VA loans. By 2020, 75% of VA loans are serviced by nonbank financial institutions.
This shift matters because banks have stronger access to liquidity in times of stress thanks to deposit insurance and access to government advances. Nonbank financial institutions do not have access to either and are reliant on external funding sources and credit lines. When hard times come, these traditional funding and liquidity sources tend to disappear.
This past April, Ginnie Mae and the GSEs developed programs to ensure the liquidity of nonbanks. But these programs were designed to help servicers make their monthly principal and interest advances on loans in forbearance. They were not designed to cover liquidation losses or foreclosure expenses.
As first-loss insurance, the VA guarantee was never intended to cover all losses from a VA loan default. In fact, historical analysis shows first loss insurance rarely covers the entire loss when a loan default. The chart below shows how frequently “no loss” and “loss” outcomes occurred for 2008-2018 originations by liquidation years. Only a third had a “no loss” outcome, where mortgage insurance covered the full losses on defaulted high LTV loans.
On VA loans, the servicer is on the hook for uncovered loan losses without reimbursement.
The VA loans are inherently riskier than GSEs loans with higher maximum LTVs (up to 100%), reduced documentation refinance programs and lower rates of MI insurance coverage. In addition, the VA servicers earn no additional risk premium for these added exposures and have little formal regulatory oversight. FHFA new capital rules for the GSEs increased the minimum capital requirements to cover second loss risk. Neither VA nor Ginnie Mae have any comparable capital requirements in place for the same type of loss risk retained by its servicers.
Historically, the VA’s portfolio was small, and the bulk of its servicing was performed by well-capitalized banks. At the beginning of the Great Recession, VA’s portfolio was only $160 billion. Today, it totals over $800 billion, 37% of Ginnie Mae’s MBS outstanding, with 75% of its loans serviced by nonbank financial institutions.
That is a 1,900% increase in VA second loss risk held by nonbanks over the past twelve years. This is where our next mortgage crisis is brewing.