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Don't Forget the 3/33 Rule

First, the good news: the overall delinquency rate on home loans stood at 4.44% at the end of the third quarter last year, 10 basis points lower than a year earlier. The bad news is that the delinquency rate was up 10 basis points from the second quarter.

To be sure, delinquency and default rates remain modest by historical standards, and nobody is predicting that they are going to shoot through the roof unless the economy takes an unexpected nosedive.

That said, it's still prudent to remember that managing delinquent and defaulted loans is a lot more expensive than managing performing, current loans. The old rule of thumb was that 3% of a portfolio that was delinquent accounted for one-third of servicing costs.

For the most part, the prognosis for loan performance is good. A growing economy has helped fuel a resurgence in job creation, a bellwether for future mortgage performance. But there are some dark clouds as well on the horizon.

The huge pool of loans originated in 2003 and later is starting to season toward its peak period of default risk.

Moreover, lenders are originating an increasing number of interest-only and payment-option loan products. Despite a relatively flat yield curve, adjustable-rate loans accounted for an increasing share of the loan market in 2005. Those products tend to be more risky than the traditional 30-year, fixed-rate loan. And some of the more exotic loan products have not been tested in tough times. Additionally, while almost no one thinks there is a "bubble" in home prices that is likely to pop, many predict that real estate appreciation will slow down this year. Some even expect prices to drift downward in high-cost markets.

All that could put upward pressure on delinquencies and defaults.

As a result, we hope lenders won't forget about their default management infrastructure. We hope the industry doesn't have to handle a big workload increase this year, and we don't see any evidence that such an increase is on the horizon. But in managing mortgage servicing shops and in pricing mortgage servicing rights, it is important to remember that delinquency rates don't just go down. They sometimes go up as well.

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