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53 » VISIT US ONLINE @ DSNEWS.COM WARNING SIGNS REMAIN AMID MORTGAGE RISK PERFORMANCE IMPROVEMENT While mortgage risk performance has improved significantly over the last few years, the industry should still be watching out for two ar- eas that raise red flags: risk posed to the industry by legacy loans and higher home price correla- tions in different markets, according to Core- Logic Deputy Chief Economist Sam Khater. Indications of improvements in the mort- gage risk performances space include tightened underwriting standards compared to the early 2000s, serious delinquencies for recent origina- tions at a 20-year low, home prices increasing at a healthy rate, and default-related metrics such as negative equity, foreclosure starts, and distressed sales all on a steady decline, according to Khater. Also, the overall economy is improving and the job market is tightening. "Going forward, watch for traditional red flags like employment, job and home price growth," Khater said. "However, we also have look for non-traditional red flags, like the perfor- mance of legacy loans, mortgage transition rates and home price volatility to get an early read on which way the market is heading." One of the areas that is a cause for concern is legacy loans, Khater said. e percentage of "scratch and dent" loans, which are loans that were 60 or more days delinquent at some point but are now current, is currently reported at 12 percent of all outstanding mortgages, which is lower than its peak of 15 percent in December 2011 but still more than double its normal level of 5 percent. e majority of these loans were originated during the housing bubble years from 2003 to 2008, a group that made up 62 percent of foreclosure starts in July 2015. By comparison, mortgages originated prior to 2003 made up only 10 percent of foreclosure starts during July. "In other words, legacy loans are the bad gifts that keep on giving," Khater said. "e persistence of legacy loans to drive foreclosures a decade later indicates how sensitive mortgage market performance is to underwriting decisions made long ago, even in an otherwise sanguine economic environment. Clearly, this means that a large segment of mortgage loans remains very sensitive to the economy and home prices." Another area of concern is the affordability of the national housing market. Price volatility is elevated, driven by high home price cross cor- relations across various markets. Also, the home price to rent ratio has been on the rise since 2012 and is currently very high, Khater said. e lower end has comprised much of the overall home price appreciation; according to Khater, real lower-end home price growth is cur- rently higher than 10 percent, partially due to the FHA reducing mortgage insurance premiums by 50 basis points at the beginning of the year. But while declining home affordability has been a much-discussed topic among mortgage professionals, much of the rise in overall home prices has come from the lower end. Real lower- end home (at 75 percent or less of median sales prices) price growth is currently over 10 percent and it was partly driven by the Federal Hous- ing Administration's decision to cut premiums earlier this year in the presence of tight supply. While decreasing affordability is not a new topic to be explored, home price cross correlations and volatility have not much less approached topics; Khater said home price correlations for the nation's 10 largest housing markets markets are three times the rate they have been in the past three decades. "Higher price cross correlations are driving higher home price volatility," Khater said. "Real home price volatility, as defined by the standard deviation of the inflation adjusted three-year moving average in price changes, is currently twice the historical average. Higher home price correlations increase home price volatility and risk of national booms and busts because the benefits of geographic diversification is reduced." WHY ARE DISCOUNTED DISTRESSED SALES NOT PULLING DOWN OVERALL HOME PRICES? When distressed properties account for a large share of all residential home sales, it tends to pull down the prices of non-distressed homes, since foreclosed and REO properties typically sell at a discount to non-distressed homes. According to data released by CoreLogic, the distressed sales share was reported at 9.7 percent as of the end of September 2015. e dis- tressed sales share has been on a steady decline for the last six years since reaching a peak of 32.4 percent (nearly one-third of all residential home sales) but at approximately 10 percent, it is still approximately five times its "normal" pre-crisis level of 2 percent, according to CoreLogic. Yet even though the distressed sales share remains high, home prices are not slowing. Ac- cording to CoreLogic's latest Home Price Index, prices appreciated at 6.8 percent year-over-year in October. A recent report from Zillow indi- cated that a lack of affordability in the housing market in urban areas may drive would-be homebuyers out to the suburbs. Why is the high volume of distressed proper- ties selling at discounted prices not pulling down the prices of non-distressed homes, as is usually the case? "e number and share of distressed sales have fallen between September 2014 and September 2015," CoreLogic Chief Economist Frank Nothaft said. "e distressed sales share in the most recent month was 9.7 percent, com- pared with 12.1 percent in September 2014. us, while distressed sales often do sell at a discount, there are fewer of them in the latest month com- pared with a year ago, so the potential negative effect on home prices has lessened over time. "Overall, the homes-for-sale inventory remains relatively lean, while demand to buy homes has increased because of an improving labor market, more optimistic levels of consumer confidence, and continuing low mortgage rates. Increased demand in the face of lean for-sale inventory has prompted further value apprecia- tion for non-distressed homes." ough the distressed sales share remained at nearly five times its pre-crisis level, the share of REO sales is down. In September, REO properties accounted for 6.4 percent of all residential home sales, the lowest level since October 2007 when it was 6.2 percent. At their peak in January 2009, REO sales accounted for 27.9 percent of all home sales. Meanwhile, in September 2015, short sales made up 3.3 percent of all residential home sales. e short sales share has been in the 3 to 4 percent range since dropping below 4 percent in mid-2014. e five states with the highest distressed sales share in September 2015 were Maryland (20.7 percent), Florida (19.6 percent), Michigan (19.6 percent), Connecticut (19.1 percent), and Illinois (18.2 percent). All but eight states had lower distressed sales shares in September 2015 compared with September 2014, but only North Dakota and the District of Columbia were down to within one percentage point of their pre-crisis levels.

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