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Default risk for nonprime mortgages fell during the first quarter.

UFA Sees Mortgage Risks Rapidly Returning to Normal

Default risk for nonprime mortgages fell during the first quarter and under current economic conditions, mortgage investors and lenders should expect defaults on loans currently being originated to be 58 percent higher than the average of loans originated in the 1990s, according to University Financial Associates’ quarterly Default Risk Index.

The UFA Default Risk Index for the first quarter of 2010 fell to 158 from last quarter’s revised 164, continuing to decline from the peak level of 330 set in 2007. UFA’s baseline scenario for the economy this quarter now has GDP growing 2.5 percent and 7 percent over the next two years, just below trend levels (3 percent). The baseline scenario uses the consensus inflation rate of 1.7 percent.

“Although UFA forecasts that house prices will continue to decline, the rate of decline has decelerated. The hardest-hit areas have begun to return to sustainable levels,” says Dennis Capozza, who is the Dykema Professor of Business Administration in the Ross School of Business at the University of Michigan, and a founding principal of UFA. “Slower house price depreciation will mitigate risk levels for mortgage lenders.”

Each quarter UFA evaluates economic conditions in the United States and assesses how these conditions will impact expected future defaults, prepayments, loss recoveries and loan values for nonprime loans. A number of factors affect the expected defaults on a constant-quality loan. Most important are worsening economic conditions. A recession causes an erosion of both borrower and collateral performance. Borrowers are more likely to be subjected to a financial shock such as unemployment, and if shocked, will be less able to withstand the shock. Fed easing of interest rates has the opposite effect.

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, that is, 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 less favorable currently than in prior years.

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