Default Risk of New Mortgages Continues to Edge Lower: Study
By: Carrie Bay
With today’s economic conditions, investors and lenders should expect defaults on mortgages currently being originated – both prime and nonprime – to be 28 percent higher than the average of loans originated in the 1990s, according to the latest UFA Mortgage Report by University Financial Associates of Ann Arbor, Michigan.
The UFA Default Risk Index for the first quarter of 2012 registered a reading of 128. The index slipped slightly compared to the previous quarter, which was revised downward from 131 initially reported to 129.
Currently, mortgage default risk is significantly lower than the worst vintages of this cycle – from 2006 to 2008 – when the index hovered around 225, which means loans made during that three-year period are 125 percent more likely to default than loans extended in the 1990s. A reading of 100 represents UFA’s baseline scenario of the 1990 decade.
UFA says the risk of default today is due solely to the local and national economic environment.
“Our baseline macro scenario is based on consensus expectations and has real GDP growing at 2.5 percent for the next two years and core inflation at 1.6 percent,” said Dennis Capozza, who is the Dale Dykema professor of business administration in the Ross School of Business at the University of Michigan, and a founding principal of UFA.
According to the UFA Default Risk Index, the risk of default for residential mortgages has been on the decline ever since early 2008, and it’s continuing to fall. However, Capozza notes that positive, unexpected economic events would reduce defaults even more.
“We believe that surprises are more likely to be on the upside than the downside of this consensus,” he explained, referring to the company’s GDP growth and inflation forecasts over the next two years.
“Upside surprises for the macro scenario would reduce defaults relative to this baseline. Currently, record low mortgage rates and accommodative monetary policy are helping to support the housing market and reduce defaults relative to what would otherwise prevail,” Capozza said.
The UFA Default Risk Index measures the risk of default on newly originated prime and nonprime mortgages. UFA’s analysis is based on a “constant-quality” loan, that is, a loan with the same borrower, loan, and collateral characteristics.
The Index reflects only the changes in current and expected future economic conditions, which UFA says “are much less favorable currently than in prior years.”
Each quarter UFA evaluates economic conditions in the United States and assesses how these conditions will impact expected future defaults, prepayments, loss recoveries, and loan values for prime and nonprime loans.
A number of factors affect the expected defaults on a constant-quality loan, UFA says. Most important are worsening economic conditions. A recession causes an erosion of both borrower and collateral performance. Borrowers are more likely to be subjected to a financial shock such as unemployment, and if shocked, will be less able to withstand the shock, according to the analytics and modeling company.
UFA was founded in 1990 by two renowned professors of finance to bring state-of-the-art analytical techniques to lenders. The principals bring over 50 years of experience in mathematical modeling and data analysis to financial problem solving.
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