UFA Default Risk Index: Irrational Exuberance
Fall 2023
The UFA Default Risk Index for the fourth quarter of 2023 has risen seventeen points from its third quarter 2023 level. The Index rose to 154 from last quarter’s revised 137 in our baseline scenario. Under current economic conditions, investors and lenders should expect defaults on loans currently being originated to be 54% higher than the average of similar loans originated in the 1990s, due solely to the local and national economic environment. That’s a key finding of the latest UFA Mortgage Report™ by University Financial Associates of Ann Arbor, Michigan.
“This week monthly data on inflation printed 0.1% lower than expected. In response financial markets ignited a "rip your face off" rally in both stocks and bonds. Since monthly readings on inflation can be "noisy" even if food and energy are excluded, it is difficult to justify such an exuberant response to a single month of favorable data. Analysts at the Federal Reserve grounded in Bayesian statistics must be both puzzled and disappointed. Such (over) reactions to economic news signals that the Fed's efforts to " curb the enthusiasm" and slow the economy are not finished yet,” said Dennis Capozza, who is Professor Emeritus of Finance in the Ross School of Business at the University of Michigan, and a founding principal of UFA. “While many economists believe that federal budget deficits as a percent of GDP that are less than the nominal growth of the economy are sustainable, federal deficits are now projected to exceed 6% of GDP over the next 10 years. With trend economic growth in the 2-2.5% range and a Fed target for inflation of 2%, projected federal deficits of over 6% have migrated into a worrisome zone. The need to finance the projected deficits may keep interest rates, including mortgage rates, elevated for an extended period with negative consequences for both housing and mortgage markets. We expect this issue to be prominent in the years ahead.”
The UFA Default Risk Index measures the risk of default on newly originated 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.
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 pioneering 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.