UFA Default Risk Index: New High for this Cycle
The UFA Default Risk Index for the third quarter of 2020 is 131, one point above last quarter’s revised 130 in our baseline scenario. Under current economic conditions, investors and lenders should expect defaults on loans currently being originated to be 31% 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.
“Mortgage and housing markets remain strong – for now – as mortgage rates at and below 3% along with trillions of dollars of virus spending have buoyed markets. Mismanagement of the COVID-19 pandemic is prolonging the expected negative impact on the economy,” 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. “Our analysis this quarter has housing prices falling about 5% more than forecast last quarter over the next five years. Expected default rates on mortgages are correspondingly higher as seen in the higher UFA Default Risk Index. The hoped-for V-shaped recovery is now looking more L-shaped.”
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.