A meter for mortgage risk.

Author:LaMalfa, Tom

The market has a new index to measure national mortgage risk on an almost real-time, granular basis. Could it be the very thing to head off a future crisis?

One can't help but wonder if the United States might have avoided a bubble and subsequent collapse in home prices eight years ago if the National Mortgage Risk Index (NMRI) had been available in 2000. Although looking back a decade or more may seem like idle speculation, we'll know in the years ahead if this index has helped the mortgage finance industry avoid another housing bubble. [paragraph] Time will tell whether a lesson has been learned. However, in the interim, folks in the mortgage and housing industries need to know more about monitoring risk, and the advent of a mortgage risk index is a significant step in the right direction. [paragraph] This article provides an overview of the NMRI, which was launched in December 2013 by the International Center on Housing Risk at the American Enterprise Institute (AEI), Washington, D.C. We'll look at the methodology and structure of the index, what goes into it, how it works and who is behind it.

Background and methodology

Many of the indexes that financial analysts, traders, secondary market executives and economists follow are created from survey results.

Examples abound: the Institute for Supply Management (ISM) Index, the Conference Board's U.S. Consumer Confidence Index, the University of Michigan Consumer Sentiment Index, the National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index, and various regional manufacturing surveys such as the Empire State Manufacturing Index.

Most of them are diffusion indexes based on survey results. A diffusion index shows the number of people saying conditions are better compared with those saying worse.

It does not weigh for size of firm, or the degree of better/worse. As a result, the index may underestimate or overestimate the strength based on input from a small number of respondents. These indexes' methodologies are not based on hard numbers but on respondents' often-subjective assessments.

That's not the way the NMRI works. This index relies on hard data provided monthly (with a one-month lag) by Ginnie Mae for Federal Housing Administration (FHA) and U.S. Department of Agriculture (USDA) Rural Housing Service (RHS) loans; by Inside Mortgage Finance for Fannie Mae and Freddie Mac loans; and by loans guaranteed by the Department of Veterans Affairs (VA), including both purchase loans and refinances.

The information provided for each loan includes the three key risk characteristics: 1) the combined loan-to-value (CLTV), 2) the FICO[R] credit score and 3) the debt-to-income (DTI) ratio--supplemented by other risk characteristics such as loan term (15-year vs. 30-year), type (adjustable rate vs. fixed rate) and purpose (primary residence vs. investor).

Each and every loan received monthly is run through a model that places it into a "periodic table" containing 320 risk baskets based on CLTV, FICO score and DTI, with adjustments made to take the other risk characteristics into account.

The NMRI measures how the loans originated in a given month would perform if subjected to the same stress event as loans were placed under in the 2008 financial crisis.

It is not like the stress tests the Federal Reserve conducts on the largest banks. Rather, this test is similar to those performed to determine an automobile's crashworthiness at 35 mph or a structure's ability to withstand, say, 130-mph hurricane-force winds.

The stressed default rate is calculated in a series of steps. First, a matrix of benchmark default rates is created. It is based on home purchase loans acquired by Freddie Mac in 2007. (Freddie Mac data is used, as it contains greater detail than Fannie Mae's.) All the Freddie loans are 30-year fixed-rate mortgages (FRMs), fully amortizing, fully documented and owner-occupied.

The loans are sorted into 320 risk buckets by combinations of the three risk characteristics already mentioned. Then the share of those loans that had defaulted by Dec. 31, 2012, is calculated. The calculated default rates therefore represent the default experience for owner-occupied, fully documented and fully amortizing 30-year FRMs purchased by Freddie Mac in 2007.

The next step applies the benchmark default rate to each newly originated...

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