How bad can the rate of mortgage defaults getx Ann Arbor, Michigan-based University Financial Associates, LLC (UFA) says it has simulated “worst case” market scenarios to help lenders’ risk managers and the industry better understand what to expect when it comes to future defaults on loans being made today, and the company has good news – it says the worst is already behind us.
In UFA’s most recent report, the company’s worst-case scenario assumes the gross domestic product (GDP) will decline five percent for two years, followed by two more years of positive one percent growth before returning to trend growth. The GDP is used by economists as a basic measure of an economy’s performance, and UFA explains that the worst-case snapshot used in its analysis is much more severe than any of the post-war recessions, however, it’s far rosier than the economic situation of the Great Depression in the 1930s.
UFA’s Default Risk Index tracks the impact of local and national economic conditions on expected life-of-loan defaults by vintage, or the year in which the mortgage was originated. Using the worst-case scenario, the Index peaks in the first quarter of 2009, and shows that nonprime loans made during that time have a 276 percent higher risk of default that the average of the 1990s. By comparison, the baseline scenario, accounting for current economic conditions, peaks even earlier, in the last quarter of 2008. And the baseline Default Risk Index is more than 100 percentage points lower than the worst-case scenario.

UFA says what this means is that the worst vintages are already behind us. Perhaps, this is because lenders have begun tightening the belt on lending standards and are spending more time ensuring borrowers are matched with the loan products that fit them. But even with today’s shift away from the stigma of the subprime mindset, other analysis, such as from the Mortgage Bankers Association (MBA), suggests that if the recession does continue to worsen and the jobless rate continues to rise, the industry will have to keep its eye on the prime, seemingly low-risk mortgages made over the past few years.
According to Dennis Capozza, professor of finance with the Ross School of Business at the University of Michigan and a founding principal of UFA, recent vintages have been much more strictly underwritten by lenders. As a result, he says we can be optimistic that the rate of defaults on outstanding loan portfolios will decline as well.
“Often when we begin to ask ‘How bad can things getx’ we are nearing a turning point in the cycle,” Capozza said. “This appears to be the case with mortgage defaults this quarter. The Index is telling us that we have already seen the worst economic environment of this credit cycle.”