On Mortgage Defaults, UFA Says Industry Headed for Recovery

The default risk associated with newly originated mortgages continues to improve, according to the analysts at ""University Financial Associates"":http://www.ufanet.com (UFA) in Ann Arbor, Michigan.

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The company's mortgage default risk index registered a reading of 132 for the third quarter of 2011. The index's baseline of 100 correlates to the default risk of loans made during the 1990s.

That means with today's economic conditions, investors and lenders should expect defaults on loans originated in Q3 to be 32 percent higher than the average of loans originated in the 1990s, according to UFA.

The company’s current default risk assessment of 132 is down from last quarter’s revised reading of 133. As recently as the first quarter of this year, the index reading was 141.

UFA noted in its report that the latest index readings are “much less than the worst vintages of this cycle,” referring to mortgages originated from 2006 to 2008,

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when the default risk index came in well above the 200 mark.

Dennis Capozza is the Dale Dykema professor of business administration in the Ross School of Business at the University of Michigan and a founding principal of UFA.

He says at this rate, “normalcy may not be far away” for indicators such as expected defaults and expected prepayments.

“Mortgage risks may be returning to near normal levels,” Capozza said. “However, lenders and investors must exercise caution, because high unemployment, inflationary U.S. monetary policy, and financial contagion from Europe are continuing risks for the U.S. economy and for mortgage markets.”

UFA’s default risk index measures the risk of default on newly originated prime and nonprime mortgages. The firm’s analysis is based on a “constant-quality” loan, meaning a loan with the same borrower, loan, and collateral characteristics.

Each quarter, UFA evaluates economic conditions in the United States and assesses how these conditions will impact future mortgage defaults, prepayments, loss recoveries, and loan values.

The company says the most important factor affecting expected defaults on the “constant-quality” loan is worsening economic conditions. UFA explained that a recession causes an erosion of both borrower and collateral performance.

UFA says ""its mathematical models"":http://www.ufanet.com/research1.asp 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.