Default Risk Rises Slightly

The UFA Default Risk Index for the summer of 2005 edged up slightly but remained below a historical average, suggesting that the risk of default on newly originated, nonprime mortgage loans remains fairly stable.

University Financial Associates, Ann Arbor, Mich., noted that since 2003, the index has risen steadily. Although housing prices continue to rise faster than the historical norm, the rising default index reflects the increasing probability that house prices will revert and appreciate at rates below trend.

Dennis Cappoza, professor of finance at the University of Michigan and a principal in UFA, said that above-trend home price appreciation has helped the index, but that the prospects for future increases in home values are "eroding." Still, the confluence of factors currently affecting the market means that default risks are moderate.

"Basically, we have been in an extremely strong period for the underlying collateral and for the overall economy," Mr. Cappoza told WorkoutWire.

Those factors affecting the market include low interest rates, falling unemployment and rising household incomes in addition to home price appreciation, he noted.

"We are basically hitting on all eight cylinders right now," he said.

A high level of refinancing also diminishes defaults, since prepayments and defaults function as "competing hazards" for mortgage investors, he said.

The index does not take into account the impact of Hurricane Katrina or related economic activity, he said. Mr. Capozza said it is too early to know what impact Katrina and the rebuilding effort will have on mortgage default risk. However, he noted that the rebuilding effort could provide a local economic stimulus for the affected area.

Under current economic conditions, mortgage lenders should expect defaults on loans currently being originated to be significantly higher than the average of loans originated in 1998 to 2003, but 22% less than the average on mortgages originated in the 1990s.

The quarterly analysis for the summer of 2005 reflects the life-of-loan impact of mortgage rates as well as revisions to the housing data.

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