Will COVID-19 Lead to Global Forbearance In Credit Markets? Reflections from Orrick’s Finance Sector Leader

March.15.2020

The global market for credit is estimated to be more than $200 trillion, approximately three times larger in aggregate than the global equity market. It consists of bank loans, sovereign and sub-sovereign debt, corporate bonds, mortgage and asset-backed securities, and other debt-related instruments, and is closely tied to the derivatives market. As COVID-19 spreads and social distancing causes economic activity to slow, interconnected market participants face difficult choices regarding failures to make payments and other contractual breaches.

Sovereign and sub-sovereign bonds are unlikely to experience significant payment defaults in the near term. Even as tax revenues decline, most governments will have sufficient funds to make pay debt service payments for a while. Corporate bonds may become distressed more quickly than government bonds, but actual payment defaults should be relatively rare over the next few months.

The picture looks different for bank loans, debt-based securities (ABS, RMBS, CMBS, CDOs, etc.), and related derivatives. Here, financial covenants, such as an interest coverage ratio, may be breached and a default declared even when the borrower is making timely debt service payments, which in turn may lead to cross-defaults into other financial agreements, including derivative contracts. As we saw in 2008, an expanding web of defaults can ensnare extended chains of seemingly unrelated counterparties and ultimately cause credit markets to seize up.

Governments are quickly waking up to these concerns as COVID-19 spreads and social distancing continues to slow the global economy. The Italian government, for example, began talking in late February about relieving homeowners from having to make utility and mortgage payments, and nationwide suspension of mortgage payments was announced on March 10. More recently, in the United States, Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) all sent out “reminders” to loan servicers and borrowers about the possibility of forbearance in respect of loan payment defaults.

Italy and the United States have markedly different debt markets, however. The entire Italian mortgage market totals less than $500 billion, and less than 20% of Italian households have mortgage debt. By comparison, the United States has about $11 trillion of residential mortgage debt, much of which is packaged into mortgage-backed securities with complex covenants and, in many cases, related derivative contracts. The United States also has a comparatively decentralized federal system in which overlapping state and federal laws and regulations govern financial transactions.

As the possibility of systemic problems in global debt markets becomes increasingly real, it is unclear whether the political will or legal means exist to formally mandate a period of “global forbearance” in which financial counterparties would be compelled temporarily to accept non-payment and contractual breaches without exercising remedies. This is particularly the case in certain large Western economies such as the United States, the United Kingdom, and Canada. Unfortunately, this leaves central bankers and policymakers with few alternatives other than trying pump enough cash into the right hands to keep payments flowing even as underlying economic activity comes to a virtual halt.

The Federal Reserve System of the United States is currently under pressure to cut its target interest rate to zero, as the European Central Bank did several years ago. In addition to monetary stimulus, governments are considering various forms of fiscal stimulus such as delayed tax collections, loan guarantees, and direct government spending. They should also be pushing for global forbearance by financial counterparties.