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Default Risk Index Finds Plateau, Lower Risk Expected as Inflation Rises

The mortgage default risk index from ""University Financial Associates LLC"":http://www.ufanet.com (UFA) registered a reading of 141 for the first quarter of 2011.

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The index's baseline of 100 correlates to the default risk of loans made during the 1990s. Translation â€" under the current economic conditions, investors and lenders should expect defaults on loans originated during the first quarter of this year to be 41 percent higher than the average of loans originated in the 1990s.

UFA notes that the current reading is ""much less than the worst vintages of this cycle,"" referring to mortgages originated between 2006 and 2008, when the default risk index came in well above the 200 mark.

The mathematical modeling and data analytics firm notes that the latest reading of 141 is up from the previous quarter's revised 127, but closely aligned to the 142 default risk recorded two quarters ago, before the recent blip in mortgage rates.

UFA says there is an important and timely story in this finding. The company stated in its report that the default risk index has found a plateau this quarter and if inflation rates continue to rise, default risks will improve more rapidly.

""The index illustrates that while default risks remain elevated, mortgage originators need not be as apprehensive about new originations,"" UFA stated.

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Dennis Capozza is a founding principal of UFA, which is headquartered in Ann Arbor, Michigan, and the Dale Dykema Professor of Business Administration in the Ross School of Business at the University of Michigan.

He said, ""Along with other indicators like GDP, consumer spending, and unemployment this quarter, expected defaults are showing a moderate recovery.""

Capozza continued, ""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.""

The baseline scenario this quarter grows GDP at 0.5 percent below trend this year; 0.5 percent above trend in 2012; and at trend in later years. Baseline scenario inflation rates are 1.7 percent.

The 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 the company notes ""are much less favorable currently than in prior years.""

Each quarter UFA evaluates how these economic conditions will impact expected future defaults, prepayments, loss recoveries, and loan values for prime and nonprime mortgages.

The company says most important are worsening economic conditions. For example, 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 says its mathematical models accurately predicted such developments as the increased defaults in Southern California in the mid-90s, recent trends in mortgage foreclosures, and the recent house price declines.

About Author: Carrie Bay

Carrie Bay is a freelance writer for DS News and its sister publication MReport. She served as online editor for DSNews.com from 2008 through 2011. Prior to joining DS News and the Five Star organization, she managed public relations, marketing, and media relations initiatives for several B2B companies in the financial services, technology, and telecommunications industries. She also wrote for retail and nonprofit organizations upon graduating from Texas A&M University with degrees in journalism and English.
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