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Mapping default zones.

Economies in various parts of the country harbor widely varying growth prospects. A new model helps forecast the areas of future foreclosure worries for lenders.

LOCATION, LOCATION, LOCATION. The axiom isn't just for homebuyers anymore, as mortgage lenders find that regional differences play a major role in determining foreclosure rates and home values.

A landmark study by Fitch Investors Service, Inc., a New York debt-rating agency, for the first time goes public with the regional economic indicators that affect mortgage default rates and home prices. The study finds major differences among regions, and forecasts that nationwide lenders will foreclose on an average of 74 of every 10,000 mortgages annually in the next five years. The study also forecasts a 14.31 percent median price rise for single-family homes in the next three years.

The highest foreclosure rates over the period will be in New York, New Jersey and Connecticut, according to the study. Other hard-hit areas will include New England, Florida, Louisiana, Oklahoma and Arkansas. The Midwest, Rocky Mountain states and Pacific Northwest have low default risk, the Fitch study finds.

In much of New Jersey, lenders will foreclose on an average of 170 of every 10,000 mortgages, more than double the national average. Foreclosures typically occur when mortgage payments are halted because of financial distress, job loss, divorce or illness.

The lowest residential mortgage default rates over the next five years will be in Washington state, Delaware and the Washington, D.C.-Maryland-Virginia corridor. Median three-year home prices are expected to increase from 27.21 percent for the Boston area to only 5.17 percent for much of New Jersey.

Fitch's model for rating mortgage debt carves the nation into 43 regions, then evaluates credit losses in pools of residential mortgages by projecting foreclosure rates and housing value trends in each region. Results help determine credit-enhancement levels for ratings on noninvestment-grade (BB through CCC) and lower-investment-grade (A and BBB) mortgage debt. Overall, more than $1.2 trillion of mortgage-backed securities (MBS) pools are held by mostly large institutional investors.

MBS ratings of AAA and AA continue to be based on an assessment of the worst-case scenarios, which were set in a study of Texas defaults in the recession of the early and mid-1980s. These rating levels are refined based on the economic stability and industry diversification of the 43 new regions. Ratings of A and BBB will be based on a blending of both the investment-grade and noninvestment-grade methods.

Regional foreclosure rates

Projections are based on regional unemployment, employment growth, personal income, industry diversification, population growth, housing starts, home sales and other factors that reflect the economic strength of each region. Forecasts of foreclosure rates and housing values are based on regional economic variables compiled by The WEFA Group of Bala Cynwyd, Pennsylvania. (The study is based on the latest available figures as of June 30 and will be updated regularly.)

The study yields some surprising results. For example, California is slowly gaining vigor after several years of a very tough housing market. San Francisco and Los Angeles straddle the national average in the default forecasts, while foreclosure risk elsewhere in California is lower than for the United States as a whole.

The model includes both equity and ability-to-pay variables. A major consideration is the behavior of unemployment rates. Unemployment seriously disrupts the income stream, and few households can make mortgage payments after the head of the household becomes involuntarily unemployed.

While the unemployment rate is useful in explaining historical foreclosure rates, the direction and magnitude of the change in the unemployment rate can be even more useful. In addition, the effect of high unemployment can be offset if the region also shows recent employment growth.

The borrower's incentive to avoid foreclosure when under financial stress rises with the amount of equity held in the home, especially equity in the form of the initial down payment. Borrower actions to avoid foreclosure also hinge on expectations concerning home prices. For example, if a borrower whose outstanding mortgage balance exceeds the market value of the home expects the value of his or her home to rise in the near future, that homeowner will act more vigorously to avoid foreclosure than if the homeowner believes there's little hope of recouping losses.

Forecasting home prices

To determine residential housing price patterns, Fitch focuses on a region's underlying economic stability, which is measured through an examination of that area's industry diversification and economic interdependence. Other factors include employment growth patterns, economic trends and residential building levels. The results of this analysis indicate how regional real estate values would hold up during a severe economic downturn.

Some regions, such as the San Francisco-Oakland area and the Los Angeles-Anaheim-Long Beach area, have more diversified economies that help stabilize housing demand during economic downturns. This would keep market values in California from dropping as low as in Texas, given similar economic conditions.

In modeling single-family home prices, Fitch isolates the key structural determinants of housing supply and demand. These include variables such as population and household growth, employment growth, the unemployment rate, income growth and measures of housing market activity, especially home sales or housing starts. Expectations concerning the future behavior of home prices can be approximated by examining the pattern of movements in prices over past periods.

Fitch also includes a measure of market depth in the equations--home sales per household. Even if some current equity is retained, homeowners may still be subject to foreclosure if they can't find willing buyers quickly enough.

Finally, Fitch includes a measure of labor market depth--employment per household--in some equations to further capture the effects of local economic opportunity. A family that requires the income from both spouses would be particularly susceptible to defaulting on its mortgage if one or both wage earners suddenly were unemployed.

Regional updates

To demonstrate how the model works to assess a region's underlying economic strength, we will look at some specific examples. Profiles of Los Angeles, San Francisco, Connecticut and Houston clearly explain the factors that help define the mortgage default model forecasts.

Los Angeles-Anaheim-Long Beach-Continuing economic woes are expected to increase foreclosures in the Los Angeles-Anaheim-Long Beach area to above the national rate for the next five years, while at the same time restraining home price growth. Foreclosures are expected to average 0.83 percent over the period. Median home prices are forecasted to rise a total of 10.9 percent over the next three years, compared with a 3.7 percent decline in home prices from 1989 to 1992.

The key employment sector has been hard hit in this region. In the fourth quarter of 1992, Los Angeles lost 97,000 nonagricultural jobs, with every employment category except services showing a decline. As a result, the unemployment rate for the region was pushed to 10 percent in last year's final three months.

Los Angeles' key manufacturing sector is still eliminating jobs, although the rate of decline has eased. During fourth-quarter 1992, employment fell 6.7 percent from the corresponding three months of 1991. Of the 97,000 jobs lost in the area, 51,000, or 53 percent, were in manufacturing. In fact, that sector has lost more than 115,000 jobs in a little more than two years.

Construction employment also has been under pressure. After losing almost 24,000 jobs in 1990 and 1991, an additional 10,000 were lost in 1992, bringing the decline to 8.1 percent. Fitch expects even further drops. Housing starts for the region were down more than 35 percent in 1992, while the value of nonresidential permits fell more than 50 percent. At the same time, office vacancy rates for the region are running at nearly 20 percent.

Personal income in Los Angeles declined 3 percent in real terms in 1991 and should drop about 1 percent for 1992. This has had a severe impact on nonmanufacturing sectors because consumers also are buying down debt. Trade employment has lost 115,000 jobs, or more than 10 percent of the sector's 1990 peak base.

Service employment appears to have stabilized after declining by 36,000 jobs in 1990 and 1991. This sector has experienced three quarters of slight-to-moderate growth, and although the number of jobs fluctuates monthly, it is at ever-higher levels. Because services account for 30 percent of metropolitan area jobs, the sector's stability is vital.

Employment in the Los Angeles area should decline another 1 percent in 1993, and housing construction also should drift lower. Economic growth will return in 1994, with housing starts climbing to 25,000 by 1995. Population growth should average 0.4 percent through 1995, but by that time, employment still will be below its 1990 peak. Fitch believes it will be some time before Los Angeles resolves its current economic woes.

Regions Ranked by Annual Foreclosure Rates
Averaged over the Five-Year Expected-Case Forecast

Washington 0.23
Delaware 0.28
Baltimore, MD 0.28
Chicago, IL 0.32
Washington, DC, MD, VA 0.33
IN, OH, WI, MI 0.34
Illinois--Other 0.34
Colorado 0.37
NC, SC, WV 0.40
ID, MT, NV, NM, UT, WY, OR 0.42
Sacramento, CA 0.43
San Diego, CA 0.44
Riverside-San Bernardino Counties, CA 0.51
IA, KS, MN, MO, NE, ND, SD 0.58
Philadelphia, PA 0.61
California--Other 0.65
Arizona 0.65
Houston, TX 0.70
AL, KY, MS, TN 0.71
Dallas-Ft. Worth, TX 0.71
San Francisco-Oakland, CA 0.73
United States 0.74
Atlanta, GA 0.76
Texas--Other 0.83
Los Angeles-Anaheim-Long Beach, CA 0.83
Georgia--Other 0.88
AR, LA, OK 0.90
Boston-Lawrence-Salem, MA 0.91
Florida--Other 0.92
Pennsylvania--Other 0.93
Rochester-Buffalo-Syracuse, NY 0.94
ME, NH, VT, RI 0.95
Orlando, FL 0.97
Miami-Ft. Lauderdale, FL 0.98
New York City 0.99
Nassau-Suffolk Counties, NY 1.02
Tampa-St. Petersburg, FL 1.04
Albany, NY 1.09
New York--Other 1.24
Massachusetts--Other 1.29
New York Metro Area 1.30
Essex-Bergen-Passiac Counties, NJ 1.43
Connecticut 1.44
New Jersey--Other 1.70

Source: Fitch Investors Service, Inc.

San Francisco-Oakland--The 0.3 percent decline in 1992 fourth-quarter employment from the prior quarter in the San Francisco area may appear encouraging versus the rest of California, but compared with the nation, it is worse. San Francisco's fourth-quarter unemployment rate jumped a full percentage point from the third quarter, to 6.9 percent, despite a small decline in the resident labor force.

Regional Single-Family Home Prices
Ranked by Rate of Appreciation (Expected Case) between
Fourth-Quarter 1992 and Fourth-Quarter 1995

 Projected Price Chg.
 Price Chg. 1989-1992
 (%) (%)

Boston-Lawrence-Salem, MA 27.21 (4.00)
Nassau-Suffolk Counties, NY 19.62 (6.99)
Massachusetts--Other 19.58 (4.27)
Atlanta, GA 18.88 3.11
Rochester-Buffalo-Syracuse, NY 18.60 6.61
Chicago, IL 18.52 21.68
Arizona 18.38 17.37
Baltimore, MD 17.82 16.60
Pennsylvania--Other 17.63 6.79
Connecticut 17.06 (14.41)
Georgia--Other 16.84 5.05
Albany, NY 16.70 8.69
Philadelphia, PA 16.68 7.96
New York--Other 15.60 2.03
United States 14.31 11.54
New York Metro Area 14.04 0.86
Florida--Other 13.96 6.73
Dallas-Ft. Worth, TX 13.84 (2.49)
Washington, DC, MD, VA 13.74 15.47
San Francisco-Oakland, CA 13.71 (3.38)
Essex-Bergen-Passiac Counties, NJ 13.39 (5.91)
Orlando, FL 13.12 11.99
Sacramento, CA 13.03 9.44
ME, NH, VT, RI 12.65 (7.95)
New York City 12.50 (5.24)
Riverside-San Bernardino Counties, CA 12.37 5.85
IA, KS, MN, MO, NE, ND, SD 12.17 11.17
AL, KY, MS, TN 11.88 15.94
AR, LA, OK 11.71 18.52
Illinois--Other 11.45 22.49
Tampa-St. Petersburg, FL 11.44 0.55
Houston, TX 11.36 30.45
Miami-Ft. Lauderdale, FL 11.23 15.17
Texas--Other 11.20 8.79
San Diego, CA 10.92 1.51
Los Angeles-Anaheim-Long Beach, CA 10.90 (3.70)
IN, OH, WI, MI 10.79 15.52
NC, SC, WV 10.76 12.81
Colorado 10.63 15.79
Delaware 9.96 1.13
ID, MT, NV, NM, UT, WY, OR 9.34 21.04
California--Other 8.87 2.77
Washington 6.06 11.89
New Jersey--Other 5.17 4.63

Source: Fitch Investors Service, Inc.

The region is forecast to average 0.73 percent annually in foreclosures for the next five years, just one basis point better than the national average for the period. The median home price is forecast to rise 13.37 percent in the next three years after receding 3.38 percent from 1989 to 1992.

Government, reflecting financial woes at both the state and local levels, was the worst-performing employment sector in this market. Trade, transportation and construction also declined. Trade has been hurt by the same weak consumer confidence that has plagued the nation. The recent acceleration in San Francisco's employment decline implies that trade employment will weaken even further before it improves.

Another negative for the area's employment situation is a rash of corporate restructuring. California's financial center is migrating to San Francisco from the south. This looks good for the finance sector long-term, but mergers currently are resulting in layoffs. Down-sizings at corporate headquarters also are occurring.

Trade with the Pacific Rim, improved construction activity and growth of financial services will support employment in the San Francisco region through 1995. Economic growth should be 1 percent in 1993 and should average 1.3 percent through 1995. Trade and services will provide most jobs, while finance and manufacturing will outperform the nation in jobs created.

A sustained housing recovery beginning this year should be built on a foundation of a 0.8 percent population growth and real income gains of nearly 2 percent. Housing starts should soar 40 percent in 1993 and jump an additional 20 percent in 1994, or from a low of 2,200 units in 1992 to 4,800 units in 1994. These gains should spur construction employment through 1995 despite continued slow activity in the nonresidential construction sector.

Connecticut--The end of the Cold War will continue to have its effect on housing prices and foreclosures in Connecticut, whose economy relies heavily on defense-related manufacturing. In the next five years, foreclosures are forecast to average 1.44 percent, the second highest rate in the nation after certain parts of New Jersey. Meanwhile, the median home price is forecast to rise 17.06 percent from fourth-quarter 1992 to fourth-quarter 1995, after falling 14.41 percent in the past three years.

Connecticut's economy continues to be fueled by manufacturing, which employed 21 percent in 1992's first half, well above the 17 percent national level. Approximately 72 percent of manufacturing employment in the region is concentrated in durable goods production.

During the late 1980s, there was a steep and unexpected downturn in the finance industry located in the region, coupled with increasingly sharp cuts in defense spending, which accounted for the lion's share of the state's manufacturing base. With decreased housing demand, home prices declined and foreclosure rates surged. Until the mid-1980s, the region had a low, stable foreclosure rate and moderately appreciating home prices.

Defense-related manufacturing employment in the state soared during the 1980s, surpassing 25 percent of total employment, as the United States modernized and expanded its military. This arms buildup bolstered Connecticut's already booming economy. However, more recently, with the breakup of the Soviet Union, defense contracts and expenditures were slashed.

This development, combined with the recent recession, devastated durable goods production. And, as manufacturing employment slid, the state's entire economy began to go in reverse. The manufacturing crisis escalated between third-quarter 1991 and third-quarter 1992, causing employment to fall 3.7 percent. Most losses were in the durable goods sector, where more than 10,800 jobs were eliminated.

The service sector failed to play the stabilizing role in Connecticut's economy during the recession that it did nationally where employment growth was positive. In Connecticut, however, services employment slipped 2 percent for the 12 months ending in third-quarter 1992. Compared with other sectors, services were least affected by the recession.

Connecticut's construction picture remains dismal. During the past three years, construction employment declined, including a substantial 14.5 percent drop in 1991. However, the first signs of a recovery appear to be emerging. Housing starts in the state rose to 10,000 in second-quarter 1992 from 5,850 in first-quarter 1991. At the same time, construction employment has increased since first-quarter 1992, rising 3.7 percent over the last three quarters of the year.

Connecticut will continue to lag the nation in terms of job growth. Indeed, in 1994, national employment should expand nearly twice as fast as the state's employment base. Ongoing declines in defense outlays over the short term should hurt manufacturing employment in Connecticut, with reductions likely over the next several years.

By 1994, manufacturing should account for about 20 percent of total employment, down sharply over the past 10 years but still well above the national average. Nonmanufacturing employment should begin to show improvement starting this year. Services, except for construction, should see the sharpest rebound in 1993, expanding payrolls by 1.9 percent. That pace should further accelerate to a 2.8 percent increase in 1994.

Houston--The Houston metropolitan area in its more recent economic doldrums has avoided the massive job losses experienced during its 1982 and 1986 downturns. However, residential home prices are expected to slow from their 30.45 percent rise over the three-year period of 1989 to 1992 to about 11.36 percent by the end of 1995.

Houston joined the nation in recession in 1992, with total nonagricultural employment posting a fourth-quarter loss of 0.2 percent. At 7.6 percent, Houston's unemployment rate was near the national average. While performing better than the United States as a whole, Houston's economic activity is below average in Texas, with Dallas showing a 0.1 percent increase in employment and San Antonio adding 2.5 percent to its work force.

The energy sector remained weak, with a 1.2 percent decline in mining employment in fourth-quarter 1992. Lower oil prices and the movement of exploration overseas weakened employment opportunities. Productivity increases also are limiting employment expansion.

This reduced mining activity was felt in manufacturing employment, which was down 2 percent in the fourth quarter. Much of the manufacturing base is still geared toward meeting demand for oil and gas field machinery. Employment in the electronics industry also has been driven down by a computer price war that has forced such producers as Compaq Computer Corporation to lay off workers to cut costs.

The best-performing manufacturing industries have been those related to construction: lumber and wood, furniture and fixtures, stone, clay and glass. Residential construction activity increased over the past three years, boosting demand for products from these sectors. Activity has slowed recently, however, as demonstrated by the 2.1 percent decline in construction employment in 1992.

Last year, gains were evident in services and trade while finance, insurance and real estate sectors lost 1,000 jobs and transportation continued to struggle. The banking industry in Houston continues to recover from the mid-1980s crisis and from employment losses resulting from restructuring and cost-cutting efforts. In transportation, the demise of Pan American Airways, Inc. and the problems at Continental Airlines, Inc. contributed to layoffs in the airline industry.

Fitch believes that 1993 calls for a return to growth that should accelerate to a pace in excess of 1.5 percent by year end. Fueling the advance will be a rebounding construction sector and international trade, particularly for exploration, drilling and refining of oil overseas. International oil exploration will help to keep Houston's income growth at rates above those of the United States as a whole.

These high-growth rates also will help expansion in service and trade. In fact, Fitch expects jobs in the service sector to expand at rates of more than 3 percent beginning in 1994. This, in turn, will help Houston continue to reduce its dependence on local oil exploration and mining.

Despite unpleasant economic news, single-family home construction is continuing its recovery in Houston, and housing starts continue their upward trend, exceeding the recent 14,000 units a year through 1997.

To rate noninvestment-grade MBS with increased precision requires realistic economic stress modeling. Fitch's unique forecasting approach provides such realism by capturing inherent volatility in 43 economies, creating a full spectrum of credit risk for a pool of mortgage loans. This approach should add liquidity to the non-investment-grade MBS market, as issuers and investors are now provided with a new analytical tool for drawing statistically valid conclusions about the performance of the real estate market in the context of overall economic performance.

James Nadler is a managing director of Fitch's Residential MBS Group; Gregory Raab is also a managing director, and Kenneth Rosenberg is assistant vice president with the Residential MBS Group. John Forde is vice president of public affairs for Fitch Investors Service.
COPYRIGHT 1993 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Nadler, James; Raab, Gregory; Rosenberg, Kenneth; Forde, John
Publication:Mortgage Banking
Date:Oct 1, 1993
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