In its most recent Mortgage Strategist, UBS examined potential mortgage market losses, looking specifically at such drivers as foreclosure and loss severity. In the study, analysts focused on subprime loans as the sector is more sensitive to housing market swings. Also, the sample size for subprime losses is much greater compared to prime and Alt-A mortgages, particularly in the strong coastal housing markets. Analysts used the same method for determining losses on prime and Alt-A collateral, and results were in line with the subprime data.
Cumulative losses could be influenced by probability of default and loss severity - two factors derived from certain rating agency methodology of modeling expected losses. Analysts defined a default as a loan that reaches foreclosure status or worse, adding that a consistent measure of loss severity that corresponds to the probability of default should include all those loans that have reached foreclosure and not only mortgages with positive losses, noting that including only mortgages with positive losses would tend to produce much higher loss severities. This becomes even more pronounced when a higher percentage of loans reach foreclosure but actually produce no losses, which has been true of coastal housing markets in the past several years.
In the report, UBS analysts noted that despite the common belief that there is a nationwide home price appreciation, most parts of the U.S. have not seen as much growth as have a few coastal states. They added that while some states like California and Rhode Island had average home prices increasing by triple digits over a five-year period, there are many states such as those in the Midwest, Southwest and South that have only seen average home price appreciation just in excess of inflation. The appreciation rate by state used in the report was based on the Freddie Mac Home Price Index.
Data presented showed that after five years of seasoning, roughly 9% of California and Massachusetts subprime loans reached foreclosure or worse. By contrast, for states that experienced slower home price increases, the average foreclosure frequencies were about double.
In terms of loss severity, as expected, there were much lower loss severities for California and Massachusetts (loss severities were in the 15% range) than for slower appreciating states, where loss severities ranged from 30% to 60%. The average loss severity for slower appreciating states is roughly 40%, which is about 2.5 times the level for states with a higher pace of price growth. Data used was on 1998 subprime collateral.
UBS stated that the current housing boom in the coastal states began in 1998 when appreciation rates in both California and Massachusetts were in single digits, growing to double digits in 2001. Over the same period, average loss severity for these rapidly appreciating states dropped to 2.5%. In contrast, loss severities of slower appreciating states dropped only slightly to roughly 33%. In short, slower states could have loss severities 10 times greater than those of faster states.
By breaking down subprime cumulative losses into two separate components, namely foreclosure frequency and loss severity, analysts found that a rising housing market is the result of lower foreclosure frequency and lower loss severity.
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