Yet paradoxically, the number of individuals filing for bankruptcy is down 12% in the past year.1 What explains this disconnect? And how might it affect investors?
Currently, there are several factors mitigating the most common reasons people file for bankruptcy: job loss, medical debt, and divorce. The CARES Act provided stimulus checks and supplemental unemployment to those out of a job. Hospitals saw a decrease in patient volumes as states required hospitals to cancel or delay procedures to ensure adequate Covid capacity. And divorce filings are down because many courts are only partially open.
Figure 1 – Number of new consumer foreclosures and bankruptcies (1/1/2003–6/30/2020, quarterly)
Source: New York Fed Consumer Credit Panel/Equifax" NY grants permission
What’s Different This Year
State and federal eviction and foreclosure moratoriums currently in place mean there’s less urgency to seek bankruptcy protection. Homeowners with federally backed mortgages, including Fannie Mae and Freddie Mac, get both foreclosure and forbearance protection from the CARES Act. The Urban Institute estimates that 70% of all mortgages are covered by this legislation2 (Figure 2). In addition, the nation’s 43 million renters received federal relief in September when the CDC issued an order to temporarily halt residential evictions until year-end.3
Figure 2 – Mortgage protection provided by the CARES Act
|Mortgage owner/Insurer/Guarantor||Number of mortgages outstanding||Share||Covid-19 relief announced|
|Federal Housing Administration||7,300,000||15%||Foreclosure and eviction moratorium, mortgage forbearance|
|US Department of Veterans Affairs||3,200,000||7%||Foreclosure moratorium|
|US Department of Agriculture||900,000||2%||Foreclosure moratorium|
|Fannie Mae and Freddie Mac (government-sponsored enterprises)||22,000,000||46%||Foreclosure and eviction moratorium; mortgage forbearance|
|Bank portfolios and private-label securities||14,600,000||30%||Some banks are voluntarily following government-sponsored enterprise guidelines for their portfolio loans|
|Total SF loans||48,000,000||100%|
To be clear, these temporary orders don’t relieve debtors of their rent or mortgage obligations. For some, these stopgap measures will provide enough time to regain a job, adjust spending, and avoid bankruptcy altogether. For others, the inevitable is simply postponed.
A spike in bankruptcies might not come until late 2021, several months after the moratoriums expire. The Global Financial Crisis provides a roadmap: While unemployment peaked in October 2009, bankruptcies didn’t peak until September 2010, or 11 months later.
Potential Impact on Portfolios
So where might a portfolio be sensitive to a wave of personal bankruptcies? And where can investors look to reduce those sensitivities? Personal bankruptcies are a micro phenomenon, so we don’t want to overstate the potential impact on the macro front. But we will highlight a few areas that could suffer from weakening personal balance sheets: non-agency mortgage-backed securities, cyclical sectors like financials and consumer discretionary, and direct real estate holdings.
- Non-agency mortgage-backed securities: Non-agency MBS – typically held by multisector bond funds and mortgage REITs – are the 30% of mortgages that aren’t backed by the federal government. Black Knight reports serious mortgage delinquencies are 1.84 million higher than February 2020.4 But collecting payments may be prohibited or impractical during the pandemic, which could lead to slower and lower recovery rates, especially if the collateral deteriorates.
Alternatives: High quality fixed income substitutes like investment grade corporate bonds and municipal bonds
- Cyclical sectors: Banks have been increasing their allowances to absorb potential loan losses caused by the pandemic. Most closely tied to the individual debtor are residential mortgages issued by smaller banks and credit cards issued by larger banks. Stay-at-home orders reduced consumer spending, so savings rates spiked and credit card debt fell, but banks think that’s temporary and credit card charge-offs are rising (Figure 3).
Figure 3 – Charge-off rate on credit card loans, all commercial banks
Source: Board of governors of the Federal Reserve System (US)
- Bankruptcy can stay on a credit report for up to ten years, which really impacts a consumer’s ability to purchase a home. We estimate that 19% of GDP is driven by the housing market. In fact, a survey by the National Association of Realtors found that 9% of home buyers in 2019 had previously lost a home to foreclosure or short sale. The median year for that sale was 2011 or eight years earlier, illustrating the long-term impact a bankruptcy can have.5
Alternatives: Traditional defensive sectors like consumer staples and Covid-defensive sectors like technology and communication services
- Private real estate: Individuals with rental real estate may be hardest hit by the rent and foreclosure moratoriums. Acting as the middleman between the tenant and bank, they have a balancing act to ensure expenses are paid and rents are collected. These landlords may need supplemental income from their investment portfolio to cover any shortfalls.
Alternatives: Income substitutes like dividend-paying stocks, investment grade corporate bonds, and municipal bonds, plus real estate diversifiers like REIT funds with exposure to the industrial, self-storage, and data center sub-sectors.
4 Copyright © 2020 “Morgage Monitor July 2020 Report.” BLACK KNIGHT®. All rights reserved. July 2020. https://cdn.blackknightinc.com/wp-content/uploads/2020/09/BKI_MM_Jul2020_Report.pdf
5 Copyright © 2020 “2020 Home Buyers and Sellers Generational Trends Report.” NATIONAL ASSOCIATION OF REALTORS® All rights reserved. Reprinted with permission. March 2020, https://www.nar.realtor/sites/default/files/documents/2020-generational-trends-report-03-05-2020.pdf
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The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.
Diversification does not guarantee a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Asset allocation does not ensure a profit or protect against loss.