A new report by Bank of America Merrill Lynch examines the credit burnout phenomenon and its potential to allow underwater, but not yet delinquent, borrowers to demonstrate their creditworthiness.

Analysts stated that this trend is present in all sectors, but to a lesser degree in prime mortgages. They reported that after 30 months of being underwater, there was a 7% decrease in the rate of first delinquency for prime borrowers, with drops of 25% and 33% in the rates for Alt-As and subprime borrowers respectively.

Credit burnout, also known as positive credit self-selection, refers to the extended time period where a borrower is “in-the-money” or underwater and where there is less of likelihood for the homeowner to exercise the default option. BofA Merrill analysts referred to it as the “distressed mortgage equivalent of rate-related prepayment burnout.”  

A byproduct of positive credit self-selection is that it eliminates high-risk borrowers who have already defaulted, leaving individuals who are much less likely to default. BofA Merrill analysts believe that investors could use this tool to find “clean pay history loans” and make relative value calculations across non-agency MBS pools.

The report noted that credit burnout could have several macro consequences on various sectors of the economy.

Analysts suggested the most significant impact is the potential that this trend will continue when housing prices begin to increase, which is based on the idea that if borrowers did not enter into a delinquency while underwater, they are much less likely to do so with positive prices.

As stated in the report, “as time passes, the relative ability of a pool of borrowers to cope with their underwater mortgage is stronger.”

In turn, analysts expect that home prices would continue to rise as first-time delinquencies fall, creating a “positive feedback loop” between the two. Credit burnout would act as a “stabilizer” for both the housing market as well as the overall economy.

However, the report warned that this phenomenon has the potential to also reverse in the coming months, as loyal yet tired underwater borrowers finally give in and default.

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