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58 | TH E M R EP O RT SERVICING THE LATEST O R I G I NAT I O N S E R V I C I N G DATA G O V E R N M E N T S E C O N DA R Y M A R K E T Technology Investment Probably Decreased Defect Risk The market for purchase loans is expected to increase despite higher interest rates. M ortgage defect risks are down, espe- cially for purchase transactions. The defect risk decreased 4.6 percent in May compared to April and was down 7.8 percent compared to that of a year ago, according to the First American Loan Ap - plication Defect Index. Accord- ing to the index, the defect risk for purchase transactions has declined almost 10 percent over the past five months. The industry's focus on enhancing mortgage technology is one of the likely reasons for the decline in purchase-loan defect risk. "It's likely that all of the investment in more digitized, automated, and efficient mortgage manufacturing and underwriting technology that's been made in recent years is begin - ning to pay off," said Mark Fleming, Chief Economist at First American. According to Fleming, the industry was entering a market that would be dominated by pur - chase demand for the next several years as the share of refinance loans declined due to "the cur- rent environment of increasing mortgage rates that follows years of persistently low rates." Since most homeowners had already benefited from the low-rate environment, "they now have little financial incentive to refinance or sell and buy again," Fleming said. The overall Loan Application Defect Index indicated that the frequency of defects, fraudulence, and misrepresentation in the in - formation submitted in mortgage- loan applications decreased by 2.4 percent in May over the previous month and by 3.6 percent when compared to May 2017. The defect index for refinance loans re - mained unchanged from the pre- vious month but was 4.4 percent higher than a year ago. Despite the obstacles of a high-rate environment, Fleming said consumers would continue buying. "Lifestyle decisions will still incentivize people to buy," Fleming said, explaining why the market for purchase loans was expected to grow even though mortgage rates increased. As a result, Fleming said, "There's no better time to have loan-application misrepresentation, defect and fraud risk on purchase transactions on the decline than when the market share of pur - chase transactions is rising." What if Another Housing Crisis Occurs? If such a scenario happens, a high negative home equity rate would reappear. W hile some econo- mists are start- ing to predict another housing crisis, opining on when and how it will happen, the New York Fed seeks to answer the question, "Are we prepared for another housing crisis—or even just a slump in home prices?" The answer, according to the New York Fed: "The household sector is still vulnerable to severe house-price declines, although it has become steadily less risky in recent years." This is the opinion of New York Fed researchers Andreas Fuster, Benedict Guttman-Kenney, and Andrew Haughwout in their report, "Tracking and Stress- Testing U.S. Household Leverage." The researchers tracked house - hold leverage, the ratio of housing debt to home values or LTV, not- ing a "strong correlation between a borrower's leverage and their propensity to become seriously delinquent." In fact, the researchers assert, "High household debt is widely considered one of the main causes of the Great Recession and the slow recovery that followed." As of 2017's first quarter, 3 per - cent of borrowers are underwater and 78 percent have a combined loan-to-value ratio lower than 80 percent. (The combined LTV takes second liens into account in addition to first mortgage loans.) If national home prices slip to their levels of just two years ago, the underwater ratio will rise to 9 percent. If prices fall to the level recorded four years ago, the tide will rise, resulting in a 21 percent negative equity rate. In a more dramatic "stress test," the New York Fed predicts a 38 per - cent negative equity rate in the case of a "peak-to-trough house-price drop" mimicking that of the Great Recession. At this point, just 38 percent of homeowners would have a combined LTV rate below 80. "Unsurprisingly, this outcome would be worse than at the height of the bust, since in many areas of the country, house prices have not yet recovered to the same peaks from which they previously fell," the New York Fed study stated. The "sand states" that fared poorly during the last housing crisis would again flounder. The rate of underwater homeowners in Nevada would be near 50 per - cent. In Florida, the rate would be 35 percent; in Arizona, 31 percent; and in California, 23 percent. The New York Fed conducted similar stress tests to determine the seriously delinquency rates in cases of pricing downturns. Were housing prices to remain steady, the researchers predict a 4.2 percent serious delinquency rate over the following 24 months, start - ing with the first quarter of 2017. If housing prices drop to their levels of two years ago, that rate would rise by just one percentage point. If prices fall to their four year- ago levels, the serious delinquency rate would be 67 percent above the base, reaching 7.0 percent. In a crisis "peak-to-trough" sce - nario, serious delinquencies would rise to a substantial 9.9 percent of all outstanding mortgages. Again, the most severe rates would be seen in the "sand states." The New York Fed also com - pared leveraging among types of loans, saying, "Unsurprisingly, since the GSE and portfolio loans are the least levered, they have the lowest projected delinquency rates across scenarios." In fact, projected serious-delin - quency rates in a crisis similar to the last one would be twice as high for government loans as for GSE and portfolio loans. The New York Fed conducted its stress tests at the county level to reveal the varying impact on different markets. As can be expected, "The scenario proves to be especially harsh for regions where house prices have not recovered from their troughs."