RealEstateEconomyWatch.com

The potential default risk on nonprime mortgages that were closed in the first quarter rose to the same level as loans closed last spring and fall after a drop in the fourth quarter, according to the UFA Default Risk Index, which measures the risk of default on newly originated nonprime mortgages. 

The rise in the index from 127 to 141 for the first quarter of 2011 returned it to a level near the 142 two quarters ago before the recent blip in mortgage rates. This quarter’s changes reflect the life-of-loan impact of rising inflation rates as well as the weakening of the collateral markets. Under current economic conditions, nonprime investors and lenders should expect defaults on loans currently being originated to be 41 percent higher than the average of loans originated in the 1990s.

“With other indicators like GDP, consumer spending and consumer confidence this quarter, expected defaults are showing a moderate recovery,” says Dennis Capozza, who is the Dale Dykema Professor of Business Administration with the Ross School of Business at the University of Michigan and a founding principal of UFA. “Although expected default risks are still elevated, we anticipate they will continue to improve slowly. However, if inflation rates keep on rising, default risks will drop more quickly, and this will bring about a faster recovery in mortgage and housing markets.”

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 are 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 nonprime loans. A number of factors affect the expected defaults on a constant-quality loan. 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. Fed easing of interest rates has the opposite effect.