With interest rates dropping 4 reasons there will be a large increase in foreclosures?

The market keeps predicting a goldilocks scenario with 100% certainty where inflation falls without much if any impact on residential real estate. The “soft landing” will occur at the same time interest rates have skyrocketed and supposedly the consumer is strong enough to weather the storm. In conjunction, the federal government is selling 3 times as many bonds as pre pandemic to finance the debt and yet the market is pricing in subststantial rate cuts next year. Why will foreclosures increase next year regardless of the best-case scenario?

Soft landing in sight

If you open any financial publication, there is almost universal agreement that a soft landing scenario is within reach. Here is a clip from a recent Wall Street Journal article:

“The U.S. economy is approaching what most economists had thought either unlikely or impossible: inflation returning to its prepandemic norm without a recession or even much economic weakness, a so-called soft landing.

“What we are expecting now is a soft landing,” said Nancy Vanden Houten, lead U.S. economist at Oxford Economics. “We expect the economy to weaken quite a bit, but it does look like we’ll avoid an outright contraction” in gross domestic product.

Six months ago, the consensus among economists surveyed by The Wall Street Journal was that the economy would enter a recession over the next 12 months. In October’s survey, the average forecast of economists was for no recession. “

Well’s Fargo summed up the current risks:

“It’s a pipe dream,” says Wells Fargo Investment Institute’s Sameer Samana. “Either the economy will reaccelerate and inflation along with it, which will lead to the Fed starting another round of rate hikes and there will be a harder landing later. Or, the soft landing will quickly turn into a broader and deeper economic slowdown.”

Considerably more downside risks than upside risks

I would agree with the Well’s Fargo analysis that there is considerably more downside risks than positive surprises.

Employment: We are already seeing a softening of employment which is welcome news for the federal reserve, but it could go too far in 2024. I’ve recently heard several announcements on large scale layoffs from Amazon, Chase Bank, various real estate firms, mortgage companies, and others.
Credit tightness: At the same time employment teeters, credit is still tightening considerably. Every bank has pulled back from lending and the secondary markets are pricing in a huge risk premium for mortgage-backed securities. This lack of liquidity in the market will lead to a slowdown in business spending/investment.
Federal debt increases rates: Most economists are now predicting a series of rate cuts by the federal reserve next year. Even if there predictions are correct, this likely will not have huge impacts on the market as the federal deficit keeps growing exponentially. This leads to more bond sales, basic economics tell us that more supply with stagnant demand leads to lower prices. Furthermore, under the goldilocks scenario predicted, the economy would be in a good place by mid next year allowing for the fed to lower rates. If this is true then there would be less demand for government bonds as there will not be a huge demand for extremely safe assets. I don’t see the deficit getting resolved anytime soon.
Commercial real estate: Commercial real estate values are down 40% plus in some asset classes like office. At some point these losses must be recognized which will ultimately lead to less lending, less investment, etc… and could have a spillover effect into the general economy. Remember most commercial securities are held by hedge funds, retirement funds, insurance companies, etc.. as they were historically considered safe assets. With huge losses this will eventually flow through to whomever owns the security instrument.

Unemployment will be different this cycle

Before getting into the discussion on mortgage defaults it is important to note that unemployment will be very different this cycle than 2008. Most of the recent layoffs have been in higher paid knowledge workers. Take for example Chase bank which is cutting several thousand employees that includes vice presidents, department heads, etc… all of whom make good salaries that are well above min wage. The same thing is happening at Amazon where they are cutting employees supporting their Alexa product. In 2008 we saw considerably more layoffs on the lower end of the pay scale, but the opposite seems to be happening in this cycle. Furthermore, think of the real estate and mortgage industries, the employment is not sustainable with the current volumes and the recent lawsuits on realtor compensation will further the distress in the industry. In this cycle, the higher the income the higher the probability that they homeowner which will lead to foreclosures/defaults.

Foreclosures will rise in 2024

We will see a substantial increase in foreclosures/defaults in 2024. As unemployment and rates stay higher than anticipated due to huge deficit spending, eventually life catches up. 2023 was living on borrowed time as there is an expectation that a soft landing is imminent. This allowed banks and borrowers to try to buy time until the market stabilizes. Unfortunately, in 2024 the clock will run out with huge debt payments coming due for businesses and consumers at much higher interest rates. This will ultimately bite into the economy and lead to a substantial uptick in defaults as there is no more time to borrower.

Summary:

2024 will be the inflection point for the economy. For years consumers, businesses, and the federal government have kicked the can down the road living on borrowed time. In every cycle the piper must be paid and 2024 is shaping up to be the year that the road runs out for many. Billions in commercial loans are coming due that are underwater, at the same time the federal government will need to finance 33 trillion in federal debt at much higher interest rates. These events will create a turning point in the economy that will lead to an uptick in unemployment and ultimately higher defaults on both commercial and residential real estate. Stay tuned to future blogs and I’ll explain how much real estate values will reset due to the items above.

Additional reading/resources:

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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.

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Forclosure.