The Worst Is Yet To Come.(recession will lead to increased loan losses)(Brief Article)

Dennis R. Capozza is founding principal of University Financial Associates in Ann Arbor, Mich. and a professor of finance at the University of Michigan. He has extensive consulting experience with lenders and real estate-related firms and has contributed more than 100 articles to journals and books. Dr. Capozza is a leader in integrating the modern theory of finance into real estate and lending and has pioneered the use of contingent claims and arbitrage methods to value mortgages and mortgage-related instruments.

Recent events have heightened concerns that the U.S. economy will experience a recession in the coming months as hundreds of thousands of workers are laid off and consumer spending falls precipitously. Research by University Financial Associates LLC takes into account historical economic and loan performance and provides insights into when and how a recession will effect mortgage lenders.

UFA recently created scenarios that correspond to the macroeconomic performance of the U.S. economy in two recent recessions - (1) the early 1980s, and (2) the early 1990s. These two recessions were quite different. The 80s recession initially was accompanied by high inflation rates and rising interest rates, whereas during the 90s recession, interest rates fell. In both cases loan losses increased. In the 80s, however, prepayments fell while during the 90s recession, prepayments rose. The results are specific to nonprime mortgage loans. Performance of other loan types will differ.

The results of UFA's research are summarized as follows:

* Weak economic conditions have a delayed effect on loan losses, with the impact stretched out over several years. Performance of loans originated at the beginning of a recession erode steadily for three to four years from the start of the recession before beginning a recovery. At the worst of the decline, loan losses are 10%-20% higher than in a baseline scenario.

* Life-of-loan defaults increase only modestly (by between 5% and 10% for loans written at the beginning of the recession).

* Localized economic conditions will have a substantial effect on loan losses. Losses will be highly concentrated in some geographic areas while others will be largely unaffected. Currently, parts of New England and the West are highly vulnerable. In the most severely affected areas, losses can increase several fold.