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Mortgage Risk Improves, but Watch for Red Flags

Legacy loans and home price volatility signaling “caution”

Sam Khater    |    Mortgage Performance

Mortgage risk performance is improving, but there’s still a ways to go. Two red flags in particular need to be watched by the industry: the major risk still posed by legacy loans, and higher home price correlations across various markets.

First the good news: Mortgage underwriting is relatively tight compared to the early 2000s, and serious delinquencies for recent originations are at a 20-year low. Negative equity, foreclosure starts, and distressed sales are all down and home prices are growing at a healthy clip. The high share of cash home purchases (about 31 percent currently) is also decreasing the overall leverage, because most cash sales are from someone that previously had a mortgage. Lastly, the overall economy continues to improve and the labor market continues to tighten.

However, there are some worrisome signs. The percent of “scratch and dent” loans, which are loans that were previously 60 days or more delinquent but cured and are currently still active, is currently 12 percent of mortgages outstanding – or about 5.5 million loans outstanding. It is down from the peak of 15 percent in December, 2011 but it remains well above the normal range of 5 percent.

The bulk of these loans were originated between 2003 and 2008, and this group accounts for 62 percent of foreclosure starts as of July 2015 – a much higher persistence than in the past. For comparison, the pre-2003 cohort comes to about 10 percent (though even that has risen a little in recent years, by about 200 basis points). In other words, legacy loans are the bad gifts that keep on giving. The persistence of legacy loans to drive foreclosures a decade later indicates how sensitive mortgage market performance is to underwriting decisions made long ago, even in an otherwise sanguine economic environment. Clearly, this means that a large segment of mortgage loans remains very sensitive to the economy and home prices.

Looking at home prices, the national market is becoming unaffordable, price volatility is elevated, and home price cross correlations nationwide remain quite high. The home price to rent ratio is very high, and has been increasing since about 2012. Much of the rise in overall home prices has come from the lower end. Real lower-end home (at 75 percent or less of median sales prices) price growth is currently over 10 percent and it was partly driven by the Federal Housing Administration’s decision to cut premiums earlier this year in the presence of tight supply.

While decreasing affordability is not a new topic to be explored, home price cross correlations and volatility is much less researched. Home price cross correlations for 10 large markets are currently 3 times higher than the three prior decades. Higher price cross correlations are driving higher home price volatility. Real home price volatility, as defined by the standard deviation of the inflation adjusted three-year moving average in price changes, is currently twice the historical average. Higher home price correlations increase home price volatility and risk of national booms and busts because the benefits of geographic diversification is reduced.

Going forward, watch for traditional red flags like employment, job and home price growth. However, we also have look for non-traditional red flags, like the performance of legacy loans, mortgage transition rates and home price volatility to get an early read on which way the market is heading.

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