The global crisis caused by the COVID-19 pandemic has changed our lives innumerably, and as every day passes, we uncover segments of society and the financial markets that are disproportionately affected. One area that is experiencing significant disruption is the market for government loans, which are home loans offered through the Federal Housing Association (FHA) and the Department of Veteran's Affairs (VA). These loans are made to low-income borrowers, those with low credit scores, and anyone with less than 20% equity.
The mortgage industry consists of many different participants – borrowers, lenders, servicers, insurance companies, investors, and the Federal Government – to name a few. Each participant plays an important role in a fully functioning mortgage market, so there are many ways that an economic crisis can disrupt the system. Let’s dive into how the current economic crisis is impacting the market for government loans.
How mortgage lending works
Lending is an evaluation of risk. When banks and mortgage companies lend money they assess the likelihood that a borrower will be able to make their monthly payments and pay back the full amount of the loan plus interest by the end of the term, or sooner if they sell their home, refinance their mortgage, or pay off the loan.
The interest rate that lenders charge to borrowers is based on their evaluation of risk*, the expected life of the loan, and investor demand for residential loans. If a lender perceives a loan to be higher risk, they will charge higher interest rates so they can be financially compensated for that additional risk. The market for interest rates is determined by two things:
1. What investors are willing to pay for residential loans when they are packaged and sold as mortgage-backed securities (MBS) in the secondary market.
2. How investors value these fixed-income securities relative to other investments such as government or corporate bonds.
How the economic crisis is disproportionately impacting certain borrowers
The current economic crisis is both massive in scale and unique. The stock market entered into a bear market, erasing trillions of dollars in wealth. The government bond market, which typically serves as a safe haven when stocks go down, also sold off (with investors preferring the safety of cash.) This behavior shows how investors have struggled to understand the full impact of this public health crisis and how it will ripple through the economy. In particular, investors are grappling with the impact that stay-at-home directives will have on unemployment, which tends to be a harbinger for economic calamity and a housing crisis. Investors are also closely monitoring what actions the Federal Government will take to protect the US economy from further damage.
As a result of this uncertainty, investor demand for mortgage-backed securities has waned, and the capital available is only being allocated to the highest quality borrowers and transactions that are perceived to be lower risk (i.e. prime to super-prime loans). This flight to safety is causing a spike in interest rates for higher risk loans such as those offered by the Federal Housing Administration and the Department of Veterans Affairs. The Federal Reserve has committed trillions of dollars to buy government bonds and mortgage-backed securities in an effort to bring liquidity to these markets and calm investors’ fear, but so far this capital has only been allocated to conforming loans, which exacerbates the liquidity crisis for government loans.
For example, a borrower with 740+ credit and 20% down that is securing conventional financing can expect interest rates near historic lows. On the other hand, a borrower with a credit score below 640 and less than 20% down can expect interest rates a full 1% - 2% higher than what was available just a few weeks ago, if financing is even available at all. The spread between rates for conforming loans and government loans has widened substantially because of the lack of capital and investors demanding abnormally high returns for the additional risk.
The Federal Reserve acted swiftly to bring liquidity to financial markets in an unprecedented fashion, and state and local governments are doing their best to address the public health crisis and the scope of the economic crisis. However, the market for FHA and VA loans seems to be one area the Federal Reserve hasn’t accounted for yet. As we wait for action from the Federal Reserve and for investors to calculate the full impact that this crisis will have on borrowers and property values, we will continue to see borrowers with riskier profiles forced to pay disproportionately higher interest rates or miss out on financing completely.
At Own Up, we understand people’s frustrations upon suddenly finding themselves without options that existed just weeks ago, or facing significantly worse terms. We’re staying on top of new developments and monitoring market conditions so we can help all of our customers achieve their home financing goals.
*How Lenders Evaluate Risk:
When evaluating risk, lenders assess a borrower’s credit profile and the property they are financing, which serves as collateral for the loan. When evaluating a borrower, lender’s assess three factors:
- Creditworthiness - This is measured using credit scores from the three major Credit Bureaus. The higher the credit score, the less risky the borrower.
- Debt-to-Income (DTI) - This ratio is an assessment of the borrower’s capacity to consistently make their mortgage payments on time.
- Loan-to-Value (LTV) - The difference between the value of the home and the outstanding balance of the loan is how much equity a borrower has in the home. This ratio determines how much a borrower stands to lose if they stop making loan payments.
To evaluate the subject property, lenders rely on third-party appraisers to inspect the property and provide an estimate of the fair market value of the property.