As the mortgage market’s refinance volume declines, lenders likely will respond with more flexible underwriting standards as they seek to qualify borrowers for purchase loans, an action that may gradually increase credit risk.
In addition to an uptick in credit risk, the market’s evolution into a purchase market is expected to increase the risk of fraud, says Frank Nothaft, chief economist at CoreLogic.
In CoreLogic’s fourth quarter Housing Credit Index (HCI), borrowers for purchase loans had an average credit score of 737, an average loan-to-value of 87.1 (up slightly from 86.7 a year ago), and an average debt-to-income of 36%, the same as a year ago.
CoreLogic’s HCI measures mortgage credit risk by examining purchase loans and refinances dating back 15 years in order to track pre- and post-financial crisis activity, including prime and subprime lending segments. It includes data from all 50 states and the District of Columbia.
There were slight changes in the numbers that will be interesting to watch as we get further into 2017 and more heavily into a purchase market. For example, 48% of purchase loans had a loan-to-value of 95% or higher in Q4 2016, up from 47% in the year-ago period and up sharply from 36% in 2001. In addition, debt-to-income ticked upward with 26% of the home-purchase loans having a debt-to-income share of 43% or higher, up from 25% one year earlier and 24% in 2001.
The index was set to 100 for the year 2001, and the years 2001-2003 are considered the benchmark years. The higher the HCI number, the higher the credit risk. The HCI was above 100, indicating the riskiest period credit risk, between 2004 and 2008. It has been mostly below 60 over the past eight years and currently stands at 44.
Part of the reason for that extremely low credit risk during the fourth quarter was the large number of refinances that occurred during the period. Borrowers who are refinancing a home typically have lower LTVs and lower DTIs than borrowers who are buying a home.
Fraud Risk Rises
Although mortgage fraud has dropped significantly since the advent of more lending controls post-crisis, the CoreLogic Fraud Index rose to 122 at the end of 2016, matching its highest level from three years ago. The baseline of 100 is taken from Q3 2010.
First American has also has noted an increase in fraud. The title insurance provider released its Loan Application Defect Index for January 2017, which estimates the frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications increased 5.8% from the previous month. First American said the upward trend in the index began in December 2016.
While the risk is up, First American notes that it is still down 28.4% from its peak in October 2013.
“While technology adoption has reduced risk for both purchase and refinance transactions, part of the overall decline in risk has been due to the recent dominance of refinance activity relative to purchase activity,” said First American Chief Economist Mark Fleming, as quoted in a HousingWire article. “As the mortgage market composition continues to shift toward purchase transactions in 2017, the risk of defect, fraud and misrepresentation will also increase.”
An expanding purchase market typically translates into an increase in fraud risk simply because there are more entry points for fraud to occur. During the financial crisis, we all read numerous stories of various fraud schemes in purchase mortgages, from falsified documents to straw buyers.
Fitch Ratings notes that sharply rising prices and pinched affordability could also elevate mortgage defaults and fraud in some markets. Home price gains have gotten the ahead of underlying fundamentals in the Western U.S., Texas and Florida, Fitch noted in its fourth quarter report on U.S. RMBS.
As the year progresses and the move into a purchase market solidifies, mortgage lenders will want to pay close attention to the trends in credit default risk and fraud.