UFA Default Risk Index: On a Knife Edge
Summer 2023
The UFA Default Risk Index for the third quarter of 2023 is 143, eighteen points above last quarter's revised level of 125 in our baseline scenario. Under current economic conditions, investors and lenders should expect defaults on loans currently being originated to be 43% 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.
“The Federal Reserve is walking along a knife edge, performing a risky balancing act. A misstep to one side will drop the economy into recession, on the other side into uncontrolled inflation. So far, the Fed has been masterful. A favorable core inflation reading for June produced euphoria on Wall Street, which may not be sustainable in the months ahead. Our models continue to predict more serious consequences for housing and mortgage markets. This does not mean that a soft landing is not possible; only that the model, which is based on historical experience, still thinks the soft landing scenario is less likely,” 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. “Nevertheless, there are reasons to believe that housing and mortgage markets will not be as severely impacted as in some prior downturns even if a soft landing is not realized. Housing remains in short supply in many regions, and there are few signs of overbuilding. Many homeowners have very low rate mortgages whose low monthly payments discourage default and reduce financial stresses. Finally, house prices have risen sharply in the past couple years, providing earlier buyers with a large equity cushion that will encourage financially stressed owners to sell rather than default on a mortgage.”
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.