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New Loan Defaults Now Receding?

For two consecutive quarters the UFA Default Risk Index for nonprime mortgages has been falling. The index may have reached a peak for this credit cycle with a fourth-quarter 2008 reading of 279, triple its level from the fourth quarter of 2004.

Currently, the index for the second quarter of 2009 remains elevated at 251, down from the previous quarter's revised 270 and 10% below the peak reading two quarters earlier.

This means lenders and investors can expect defaults on loans currently being originated today to be 151% higher than the average of the 1990s. That's a key finding of the most recent University Financial Associates Mortgage Report.

The risk of default for the current vintage of mortgages may finally have crested. The high level of the index in recent quarters illustrates the important role of local economic conditions in this credit cycle, since loan, borrower and collateral characteristics are held constant over time. Unprecedented house price declines in many parts of the country have brought prices closer to fundamental value, placing a floor under the borrower's equity position and making these declines in the UFA Default Risk Index possible.

This quarter's changes reflect the life-of-loan impact of mortgage rates, recession conditions and collateral markets in precipitous decline.

"The welcome news is that expected defaults on constant quality loans currently being originated has declined significantly," says Dennis Capozza, professor of finance with the Ross School of Business at the University of Michigan and a founding principal of UFA. "Of course, lenders have greatly tightened credit standards in recent quarters, so the rate of foreclosures in the serviced portfolio (all outstanding loans) should be declining soon as well, if not already. Recall that the UFA Default Risk Index predicts future defaults on loans originated today, while the foreclosure rate is the actual default rate on loans made in the past."

The UFA Default Risk Index measures the risk of default on newly originated nonprime mortgages. UFA's analysis is based on a "constant quality" loan - 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 much less favorable currently than in prior years.

According to the May 2009 Fixed Rate Prepayment Commentary from Credit Suisse, overall fixed-rate prepayments increased 7% to 27 from a 25 conditional prepayment rate.

The expected 15%-20% rise supported by the Home Affordable Refinance program implementation failed to materialize during May, said the fixed-income research and analytics team.

"Despite being operational for roughly two months, this program does not yet appear to have had much impact on refinancing weaker borrowers," said contributors Chandrajit Bhattacharya and Mahesh Swaminathan.

Most of the speed increases were concentrated in the lower coupons, which rose between 15% and 20%, 6.0s recorded moderate changes ranging from flat to up 10%, but 6.5s and 7.0s, which were expected to benefit significantly from HARP, were minimally higher or posted moderate declines, they said.

Fannie 30-year speeds increased by about 15% in May compared with a meager 5% increase posted by Freddie. Most of the differences were driven by 5.0s, 5.5s and 6.0s of 2003, 2004 and 2006 vintages.

Despite seasoned cohorts (2003-05) posting robust increases, they remain significantly slower than newer vintages (2006-09), the researchers for Credit Suisse said.

Credit Suisse said 15-year speeds posted a 3% overall increase from April, and were closer to research analyst expectations given a limited HARP-related impact on these borrowers.

Estimated May fixed-rate net issuance spiked by 163% to $84 billion from $32 billion during April, on the heels of a $60 billion increase in Fannie 30-year gross issuance, the company reported. However, $53 billion of this increase was simply securitization of seasoned loans from Fannie's portfolio.

Credit Suisse said muted increases in speeds should be positive for rolls and up in coupon. Seasoned higher coupons should continue to benefit from relatively modest absolute speeds. In addition, seasoned cohorts also offer better extension protection, the company said.

Overall slower prepayments and an outlook for declining prepayments should be supportive of the interest only and inverse interest only markets.

Analysts expect June prepays to increase about 5% mainly due to two more business days in June compared with May. But prepays should slow down on an average by 20% in July if rates persist at current levels, and 4.5s and 5.0s are expected to decline by more than 30% whereas premium coupons will decrease by lesser amounts.

"Despite a sharp drop-off in the refi index during May, we expect speed declines to be more gradual than is reflected by the refi index because of the long delays in the current origination pipeline," the Credit Suisse analysts wrote in their report.

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