A higher proportion of cash-out refinances is bringing with it increased default risk for conventional mortgages originated in the second quarter compared to earlier this year, a new report found.
The expected rate of loan delinquencies of 180 days or more for new second-quarter mortgages at some point in their life cycle increased to 2.78% from 2.28% for those produced three months earlier, researchers at consulting and actuarial firm Milliman reported. The Milliman Mortgage Default Index, or MMDI, tracks the acquisition of conventional loans by government-sponsored enterprises Fannie Mae and Freddie Mac, as well as Ginnie Mae issuances.
Although purchases made up an overwhelming majority of overall originations — 62% — the mix within the remaining 38% of refinances elevated default risk. Cash-out refis, typically done because the borrower has a need for the liquidity, made up approximately 74% of such loans in the second quarter, while rate-and-term transactions accounted for 26%.
“Cash-out refinance loans historically have higher default rates compared to rate-and-term refinancing,” said Jonathan Glowacki, principal at Milliman and author of the index. “In 2022, t.’s been an increase in cash-out refinance originations compared to the prior year, which is a contributing factor in the increased mortgage default risk we’re seeing.”
The proportional change in the second quarter represents a sharp turnaround from 2021, when the cash-out versus rate-and-term refinance mix for the entire year was 34% to 66%.
Also increasing the risk of default for both purchase and refinance loans is the expected slowdown of home-price appreciation over the next several years, according to Milliman. Several recent reports show a steadily moderating pace of home-price growth, which at one point, had surged over 20% on an annual basis by some estimates, and is expected to slow even further. More recent second-quarter data released by the Federal Housing Finance Association indicated prices starting to decline month to month in some parts of the country.
Milliman’s report comes as delinquencies of 90 days or more have gradually declined over recent months, according to Black Knight. But at the same time, cures — a change of a more serious delinquent loan’s status to current — has declined, pointing to signs of trouble a subset of borrowers might be facing as the housing market undergoes an adjustment, or normalizes.
The MMDI measures default risk based on three risk components: borrowing, underwriting and economic factors. All three components came in higher quarter over quarter.
The larger percentage of purchases in the second quarter contributed to greater borrowing risk. When compared to refinances, purchase loans are associated with higher borrower risk as it includes consumers with lower credit scores and higher loan-to-value ratios, Milliman said.
The higher share of cash-out refinances, meanwhile, drove the uptick in the underwriting risk, and the expected slowing of house prices led the economic component higher.