A new initiative of the ""American Enterprise Institute"":http://www.aei.org/ (AEI) aims to mitigate the damage of housing's boom-and-bust cycles. It utilizes a new ""Mortgage Risk Index"":http://www.housingrisk.org/sticky-post-2/ developed by a former chief credit officer of Fannie Mae and a 25-year veteran of the Federal Reserve.
[IMAGE]According to the index, mortgage risk remains high today compared to what its architects describe as the ""sound lending practices in place in 1990."" And even more troublesome, it indicates risk levels are rising.
The Mortgage Risk Index was devised by ""Edward Pinto"":http://www.housingrisk.org/members/, who was with Fannie Mae up until the late 1980s and who is now a resident fellow at AEI, and ""Stephen Oliner"":http://www.housingrisk.org/members/, a resident scholar at AEI, an organization he joined after spending more than a quarter-century analyzing the U.S. economy and financial markets for the Fed.
As they explain it, the index measures the safety of mortgage lending in the United States by quantifying how new mortgage loans would perform under stress. Using the default experience of loans originated in 2007 as a benchmark, the index gauges how today's mortgages would fare if they were hit with a market collapse on par with the recent crisis.
The two AEI researchers conclude that less than half of the home purchase loans extended in recent months can be considered low risk-despite claims that today's credit standards are too tight.
Looking at data from October, newly originated mortgages had an overall index score of 10.9 percent; this figure represents the estimated cumulative default rate under stress circa 2007. To put things into context, consider vintage 1990 mortgages carry an index score of 6 percent, [COLUMN_BREAK]
while mortgages from 2006-2007 register a cumulative default rate of 21 percent.
Looking at strictly ""Federal Housing Administration"":http://portal.hud.gov/hudportal/HUD?src=/federal_housing_administration (FHA) loans, 2006-2007 vintages have an index reading of 29 percent, compared to 23.2 percent now. FHA mortgages from the 1936-1955 era, which is considered the ""'Golden Age' of prudent FHA lending,"" according to the researchers, score a mere 3 percent on the risk index.
""Fannie Mae"":http://www.fanniemae.com/portal/index.html and ""Freddie Mac"":http://www.freddiemac.com/ scored better than the government's mortgage insurer, with a current stress-induced default propensity of 5.6 percent, versus 13 percent for 2006-2007 vintages, versus 4 percent for 1988-1990 vintages.
The data indicates Freddie's share of low-risk loans has remained stable over the past year at 70-75 percent. Fannie's low-risk is considerably lower at about 63 percent, and it's declining, according to Pinto and Oliner.
Even so, all index results for purchase loans with a federal guarantee ""are high relative to prudent standards and have edged up lately,"" Pinto and Oliner conclude.
With coverage of home purchase loans acquired and securitized by Fannie Mae or Freddie Mac, or guaranteed by FHA or the Rural Housing Service (RHS), the national Mortgage Risk Index encompasses about 85 percent of all the market's new mortgages and nearly 100 percent of government-issued mortgages, according to Pinto and Oliner.
They plan to add loans guaranteed by the Veterans Administration (VA) to the index in 2014, as well as loans without any form of government backing. The index will also be expanded to include refinancing loans later in the year.
So why measure mortgage safety under economically stressful conditions? Pinto and Oliner point to the fact that cars are safety-rated for crashworthiness at 35 mph, not 5 mph, and homes in the paths of hurricanes are rated for safety based on 125 mph winds, not 30 mph. Similarly, they say, mortgage loans should be risk-rated under the stress of a substantial drop in home prices-not flat or rising prices.
According to the pair, ""Lessons learned from loan performance under extreme stress also can substantially reduce default rates and market losses during periods of moderate stress and help provide market stability.""