Whither Credit Quality

By most accounts, the economy seems to be improving. Confidence is increasing, and economic growth seems to be at least stabilizing, and perhaps gaining steam. But so far, that hasn't shown up in the employment statistics. At 6.1%, the official unemployment rate hardly seems to have reached crisis proportions. But beneath the statistics are some troubling trends. The proportion of people who remain unemployed for more than half a year has been rising. And an increasing ratio of people who describe themselves as "self-employed" in the Labor Department's survey might mask additional unemployed or underemployed households.

So it doesn't come as a big surprise that some economists, including Mark Zandi of Economy.com, think that mortgage credit quality may continue to erode next year even if the economy improves. But the main factor behind worsening credit quality may not be the job situation, it may be interest rates. Rising rates are likely to put a damper on house price appreciation, which has already slowed from its heady pace in recent years. And home price gains, along with lower interest rates, have helped to prop up credit quality in recent years.

Falling rates allowed many borrowers to reduce their monthly mortgage bill. Higher home values strengthened loan- to-value ratios. Now, conditions may be changing.

Rates remain low by long-term standards, but stronger economic growth may translate into higher interest rates yet. And a burgeoning federal deficit also may add to upward pressure on interest rates.

That will make buying a home less of a bargain for many people. In turn, weaker demand may soften home price increases. In short, it will become more difficult for homeowners who find themselves in economic hardship to sell the house, pay off the loan and move on with their lives. More loans could end up in default as a result.

We hope this prediction does not come to pass. So far, MBA data has shown overall delinquency rates to remain within acceptable levels, despite an increase in foreclosures.

But lenders need to be prepared in case they do see a rising foreclosure workload next year. After all, Mr. Zandi's prediction cannot be taken lightly.

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