YOU ARE LIKELY FAMILIAR with the annual mortgage origination cycle: Home purchase origination volumes are higher in the summer and lower during winter. What you may not know is there also is a subtle quality difference associated with the annual cycle. 11 Typically, when volumes are high, average loan quality is also high. Lenders tackle layered risk loans throughout the year, but as purchase volumes subside, originators have more capacity to complete these more challenging loans.
Hence, the average loan closed during low-volume periods is one with more risk. This column discusses the interest-rate-related quality cycle over and above the subtle annual cycle.
Quality differences in the interest-rate cycle
In 1986, 1993 and again in 2003, mortgage interest rates experienced significant declines, resulting in huge waves of originations. Lenders added staff to handle the increased volume. As with high-volume periods of the annual cycle, many high-quality loans were processed early in the low-rate frenzy, leaving the less-vanilla loans to dominate near the end of the cycle.
As volumes declined, origination shops, trying to retain experienced staff in case rates dropped again, were willing to tackle loans that were more complicated to process or approve. Thus, quality waves rippled through origination vintages.
Looking at 2003-2006 as an interest-rate and quality cycle
To illustrate this, Figure 1 shows the average credit score for recent origination vintages (thin red line) along with the average credit score for outstanding loans (blue line).
The first item to note is that rates dropped to historic lows of just over 5 percent for 30-year fixed product in early 2003. The vintage of 2003 was originated at an average credit score consistent with the national average of 720--the high-quality ripple from that rate cycle.
Mortgage rates hovered around the same level, plus or minus 50 basis points, through 2006. But consistent with past quality cycles, the origination process had absorbed all the vanilla loans by then and were focused on the more complex loans. Between 2003 and 2006, the average credit score for loan originations dropped steadily to a low of 700.
What isn't shown in the figure (but will be addressed in future columns) is the increasing layered risk of the low-credit-score vintage. Affordability products, low-document loans and other layered risk attributes were rampant.
These These years between 2003 and 2006 comprise an extended...