Despite tighter lending standards enacted by mortgage lenders beginning in 2007 and new regulations like the QM Rule, the risk of mortgages originated today is 13 percent higher than it was in the 1990s.
The Default Risk Index for the second quarter of 2014 rose to 113 from last quarter’s revised 112 in our baseline scenario. Under current economic conditions, investors and lenders should expect defaults on loans currently being originated to be 13 percent higher than the average of similar loans originated in the 1990s.
The UFA Default Risk Index measures the risk of default on newly originated 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 are less favorable currently than in prior years.
“As the US economy approaches full capacity, closer monitoring of inflation risks is worthwhile,” said 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 University Financial Associates. “Changes in inflation rates have an impact on the timing of mortgage default risks because higher inflation raises mortgage rates and the current cash flow costs of owning a home. At the same time, inflation raises futures prices and lowers the longer term risks. The Federal Reserve is undoubtedly watching metrics of economic capacity, such as industrial capacity utilization and unemployment, and assessing inflation risks. This quarter, we are close to levels that might begin to place pressure on prices; but we are not there yet.”
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.
UFA’s mortgage analysis has successfully predicted problems in the mortgage market well in advance including the increased defaults in Southern California in the mid-90s and the recent national mortgage crisis. Its predictions are based on an extensive analysis of local economic conditions in each state and the relationship of those conditions to loan performance. The historical record of millions of mortgage loans is studied each quarter to assess the vulnerability of each state to loan losses and prepayments. The detailed analysis of each state – including best and worst places to lend – is available in the UFA Mortgage Report, published on a quarterly basis.