Default Risk on Nonprime Loans Called 'Steady' in First Quarter

University Financial Associates' Nonprime Mortgage Report default risk index for the spring 2004 quarter is up one point from the prior quarter to 100, meaning that the likelihood of default on newly originated loans is equal to that of nonprime loans originated during the decade of the 1990s.

The index has risen by 10% since 2001 and by 20 index points since late 1998, according to the UFA, but it remains moderate by historical standards, according to UFA principal and University of Michigan finance professor Dennis Capozza.

Under current economic conditions, nonprime lenders should expect defaults on loans currently being originated to be significantly higher than the average of loans originated in 1998 and 1999 but at par with the average default rate for the entire decade of the 1990s.

While the default risk index shows deterioration in credit conditions since the late 1990s, Mr. Capozza said the index does not indicate any major problems and that overall credit conditions remain steady.

"Although house price appreciation remains robust, mortgage rates are now rising. The confluence of these trends causes the default risk to be moderate," Mr. Capozza said.

Higher rates mean that homeowners have to pay a higher percentage of their income for housing, and that makes it more difficult for them to withstand possible economic shocks down the road.

The index is based on a hypothetical "constant quality" 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. It is also forward-looking in nature, predicting the future risk of defaults on newly originated loans rather than the risk of default for existing loan portfolios.

The index reflects how economic conditions in the United States will affect future defaults, prepayments, loss recoveries and loan values for nonprime loans. Economic conditions affect both the collateral and borrower performance.

For instance, a recession causes an erosion of both borrower and collateral performance, because borrowers are more likely to be subjected to a financial shock and less able to withstand such a shock.

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