Restoring Default Risk to Pre-Bubble Levels Will Take Five Years

Written by: Steve Cook   Wed, May 26, 2010 Beyond Today’s News, Forecasts, Recovery Signals

The risk of borrowers defaulting on their mortgages today is much less than in 2006 to 2008, but it will take at least five years for risk to return to pre-bubble levels, a leading expert on default risk told Real Estate Economy Watch

“We expect continuing improvement. Risk levels should be lower on newly originated mortgages next year barring a “double dip” recession,” said Dennis Capozza, the Dykema Professor of Business Administration in the Ross School of Business at the University of Michigan, and a founding principal of University Financial Associates, which created and publishes the UFA Default Index. 

Local economic conditions that have been building for a decade, not underwriting or moral hazard, are the primary driver or defaults.  ”Although declines usually happen faster than increases, it will still take many years to return to “normal” prices.  We are not there yet,” Capozza said.

Yesterday UFA said the UFA Default Risk has dropped to 182 in the second quarter, half the peak level of 362 set in 2007. The Index illustrates the important role that local economic conditions have played in this credit cycle, since loan, borrower and collateral characteristics are held constant over time in the Index. If, as some observers expect, inflation spikes due to excessive monetary ease, nominal house prices will be higher and defaults will be lower.

Under current economic conditions, investors and lenders should expect defaults on loans currently being originated to be 82 percent higher than the average of loans originated in the 1990s, but much less than the worst vintages of this cycle (2006-2008).

Strategic defaults, which Capozza said have always been a risk for investors when house prices decline precipitously, are already factored into the UFA forecast, which predicts declining foreclosures started; so he  does not expect strategic defaults to increase default risks.

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 are much less favorable currently than in prior years.

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