UFA Default Risk Index: Light at the End of the Tunnel or Severe Recession?

According to ""
University Financial Associates LLC"":http://www.ufanet.com (UFA) in Ann Arbor, Michigan, we can expect defaults on non-prime mortgage loans to be 48 percent higher than they were in the last decade.
Each quarter UFA evaluates economic conditions in the United States and assesses how these conditions will impact future defaults, prepayments, loss recoveries, and loan values for non-prime loans, and it measures the risk of default on newly originated non-prime 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.
A number of factors affect the expected defaults on a constant-quality loan, UFA explained. Most important are worsening economic conditions. A recession causes an erosion of both borrower and collateral performance, UFA said. In this situation, 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, UFA explained. An easing of interest rates by the Federal Reserve has the opposite effect, UFA added.
In the last six years, the UFA Default Risk Index for non-prime mortgages has nearly tripled. The index for the fourth quarter of 2008 is elevated at 148, despite falling from last quarter's reading of 167 (revised). And, the fourth quarter figure is 48 percent higher than the average index of 100 in the 1990s, UFA said.
Although the index fell this quarter, UFA's baseline scenario does not include severe recession conditions. The ""National Bureau of Economic Research"":http://wwwdev.nber.org/cycles/dec2008.html announced on Monday that the U.S. economy has been in a downturn for almost 12 months, officially crossing the threshold into a recession last December. And, UFA warns, severe recession conditions are becoming more likely every day.
The nation's top finance officials, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson, yesterday vowed to revive the economy before it reaches a state of ""severe,"" using all means at their disposal, they said.
Speaking at a Fortune 500 forum on Monday, Paulson said he was trying to slow the rate of loan defaults and home foreclosures by making sure that mortgages were available at lower cost, and he professed some disappointment that mortgage interest rates have not fallen more, according to a %{=FONT-STYLE: italic}""Reuters"":http://www.reuters.com% report.
""Given that we have essentially guaranteed Fannie Mae and Freddie Mac securities, the rates on those securities - and corresponding mortgage rates - have not come down as much as we may have hoped,"" Paulson said.
Under present economic conditions, non-prime investors and lenders should expect defaults on loans currently being originated to be 48 percent higher than those originated in the 1990s, UFA says. But, if a severe recession is realized, UFA estimates that its Default Risk Index for the current vintage of loans will be 5-10 points higher.
Dennis Capozza, professor of finance with the Ross School of Business at the University of Michigan and a founding principal of UFA, points out that currently, 20 percent of homeowners are estimated to have negative equity in their homes. ""This figure is sure to rise, since UFA forecasts additional home price declines in many states,"" Capozza said. ""If a severe recession develops as some macroeconomic forecasters expect, job losses and unemployment will rise and will exacerbate mortgage defaults as borrowers find yet another reason to walk away from their indebtedness.""
UFA was founded in 1990 by two renowned professors of finance to bring state-of-the-art analytical techniques to lenders, the organization said. The principals bring over fifty years of experience in mathematical modeling and data analysis to financial problem solving. The UFA Default Risk Index is a key component of the organization's quarterly UFA Mortgage Report. The UFA Mortgage Report has successfully predicted such industry developments as the increased defaults in Southern California in the mid-90s, as well as the current increases in defaults. Its predictions are based on an analysis of local economic conditions in each state and the relationship of those conditions to loan profitability. The organization's historical records of millions of mortgage loans are studied each quarter to assess the vulnerability of each state to loan losses and prepayments. For more information about UFA and its Mortgage Report, ""click here"":http://www.ufanet.com/nmr.htm.