Volume I, No. 1
Uncertain Times 
Lending Industry Applied Research   
and Best Practice Solutions   
Dear Subscriber:
Because you have been identified as an industry leader, you have been recommended for inclusion in an educational newsletter to share best-in-class lending industry management techniques and systems. UFA's mission is to support investors, lenders, and regulators with education and applied research to make accurate and timely predictions of risk adjusted loan profitability to create competitive advantage.

Although the future holds uncertain times, as a community we can develop strategies, best practice analytics, and tools that reduce risk and move towards more certain profit results while expanding the lending markets.
Can You Describe Your
Worst Case Scenario?
Whether you are a lender, investor or regulator, an important risk management exercise is to understand possible worst case scenarios. University Financial Associates (UFA) runs various simulations each quarter to help risk managers understand future default risks. A worst case scenario enables decision makers to quantify the downside risk and prepare mitigation strategies if prudent. With that information in place, decision makers can monitor the indicators (for example, house prices), determine ways to limit the worst risks, and maybe even know when they are seeing the light at the end of the tunnel.

In this issue, we focus on mortgage default rates as an example of how to apply a worst case scenario to your risk management practices. Other consumer lending products such as auto, credit card, and line of credit default rates, would see similar risks and timing relationships.
Are the Worst Quality-Adjusted
Vintages Behind Us Now?
Each quarter UFA calculates its Default Risk Index, which tracks the impact of local and national monetary conditions on expected life-of-loan mortgage defaults by vintage. By holding borrower credit and loan terms constant, the Index is able to isolate the effects of local and national economic conditions from the myriad of other variables that affect loan performance.  In UFA’s worst case scenario, GDP will decline 5% for two years, followed by two more years of positive 1% growth before returning to trend growth.  The worst case scenario is much worse than any of the post-war recessions but far better than the 1930s.

In this worst case scenario the UFA Default Risk Index peaks at 376 in 2009 Q1, while in the baseline scenario it peaks in 2008 Q4 at 279. In a worst case, then, the Index estimates the risk of default on newly originated mortgages at nearly 4 times higher than the average of the 1990’s. By contrast the baseline scenario peaks at less than 3 times higher than the 1990’s average. The worst case is a third worse than the baseline scenario. In either case, the worst economic environment for originating mortgages is already behind us!  This is an important result of the scenario experiment. 

What Can We Conclude
From Our Scenario?
The Index is telling us is that the worst economic environment for mortgage loans is now in the past. The loans originated in 2008Q4 and 2009Q1 are likely to default at the highest rates after controlling for other risk factors like LTV and credit scores. Given the tools to distinguish these risks, decision makers can adjust pricing and portfolio holdings appropriately for the economic environment.  Indeed it can be argued that the single biggest mistake that decision makers made in the current crisis was their failure to incorporate the rapidly changing economic environment into their decisions.  Future newsletters will discuss this issue further.
Economic Conditions and
Loan Default Rates
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 mortgage and auto loans. A number of factors affect the expected defaults on a constant-quality loan. Most important are worsening local economic conditions and house prices. 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.
A Turning Point
in the Cycle?
“Often when we begin to ask ‘How bad can things get?’ we are nearing a turning point in the cycle.  This appears to be the case with mortgage defaults this quarter [2009Q2],” says Dennis Capozza, professor of finance with the Ross School of Business at the University of Michigan and a founding principal of UFA.  “The Index is telling us that we have already seen the worst economic environment of this credit cycle.  At the same time, recent vintages have been much more strictly underwritten by lenders.  As a result we can be optimistic that the rate of defaults on the serviced portfolio of outstanding loans can decline as well.”

The UFA Index is a forward looking life-of-loan prediction for loans of the indicated vintage and can be contrasted with backward looking default rates on the serviced portfolio of past originations, such as the one that is compiled by the Mortgage Bankers Association.
Share Your Experiences
Frequently, stress tests for loan portfolios miss the future local economic, product structure, and future collateral performance risks, which can be caught two to five years early with proper risk management practices. UFA creates analytical tools to help financial institutions define future default risks and account for the effects of local economic conditions on loans. To review UFA's current research, please visit http://www.ufanet.com/research1.asp.

This newsletter will be part of a community-building activity that will be driven by you and your peers. We value your comments, suggestions, stories, and questions. We promise to be responsive and considerate, and to provide relevant updates and meaningful articles. We invite you to share your thoughts by emailing newsletter@ufanet.com or directly to me.

If you wish to stop receiving this newsletter, please click the “Unsubscribe" link below, or email me directly. If you change locations, please update us with your new email address to continue receiving the newsletters. To avoid missing an issue, add this email to your "safe senders" list (for example in Outlook, right-click on the message, select "junk mail," then select "Add sender to safe list"). You can recommend associates by forwarding their name and corporate email to newsletter@ufanet.com.

Lisa Saaf, Outreach Coordinator
(734) 995-7271
Why Inflation Won't Happen (The Business Insider)
Obama Regulatory Plan
(Wall Street Journal)
Loan Modifications: Do-able? (Mortgage Servicing News)
Imagine scoring local economic risks at the zip code level, using a hassle-free pay-per-click solution. With UFA's important innovation in mortgage and auto loan analysis, you can.
Read More

Leverage UFA's decades of experience by allowing us to develop a custom analytical solution. 
Contact Us

About UFA
Join our Newsletter Community
UFA News Archive

(734) 995-7271