Defaults on Newly Originated Loans Edge Higher

Under current economic conditions, nonprime investors and lenders should expect defaults on loans currently being originated to be 137% higher than the average of loans originated in the 1990s.

That's a key finding of the latest UFA Mortgage Report by University Financial Associates of Ann Arbor, Michigan.

The UFA Default Risk Index for the third quarter of 2009 rose to 237 from last quarter's revised 230, but remains below the 2008 Q4 peak.

After extraordinary price declines in many housing markets around the country, one might expect improvement in UFA's forward-looking Default Risk Index.

Unfortunately, steep increases in unemployment are almost fully offsetting the positive effects of lower, and in some areas, stabilizing house prices, said Dennis Capozza, professor of finance with the Ross School of Business at the University of Michigan and a founding principal of UFA.

"Plummeting house prices from overvalued levels interacting with questionable underwriting practices have been the primary driver of defaults to date in this credit cycle," says Mr. Capozza.

"As house prices return to more sustainable levels, we are transitioning to a phase where high unemployment rates will exacerbate the level and extend the period of elevated foreclosures."

When looking at the Barclays Capital, "Prepayment Outlook: Hybrid ARMs," the authors of the report say that after a near halt in originations, agency hybrid ARM issuance is showing signs of resurgence, reaching $4 billion in July.

In this prepayment outlook, the company examines trends in hybrid ARM supply. The analysts review recent origination characteristics, examine prepayments, and review valuations vs. comparable products in the agency MBS universe.

As an affordability product, they say hybrid adjustables are naturally attractive to borrowers who are either financially stretched or seeking leverage to the housing market.

"Because credit remains an overriding driver of prepayments, a drastically improved credit profile in new production hybrid pools suggests a heightened refinancing sensitivity to rates and lower default-related prepayments," the report said.

Its authors conclude, "Despite the recent uptick, hybrid issuance is unlikely to break $5 billion-6 billion a month in the near future. One reason is that dramatically tighter underwriting standards have pushed a large share of weaker credit hybrid borrowers out of the market," they wrote.

Consequently, Barclays Capital says, "hybrid net supply should remain negative in the medium term. New production pools should have a much more reactive refinancing response as a result of the better credit profile for new hybrid borrowers."

The research department here expects that hybrid discount speeds should remain robust even as a significant discount. "As an affordability product, hybrid ARMs are naturally attractive to borrowers who are either financially stretched or seeking leverage to the housing market," wrote one of the authors, Derek Chen.

"Many such borrowers have one or more credit issues such as DTI or documentation. During the housing heydays of 2004-07, the GSEs essentially used hybrid ARMs as their Alt-A program. Historically lax underwriting standards, strong HPA, and excessive risk-taking by borrowers fueled a boom in hybrid issuance. However, this has now changed, and hybrids are no longer offered to weak credit borrowers. As a result, origination has dwindled ... hybrid origination is unlikely to pick up dramatically.

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