Always current mortgage borrowers who aggressively tackle their mortgage debts are less likely to default in many cases, creating a significant indicator of 'reduced credit risk' for investors in non-agency residential mortgage-backed securities, Credit Suisse analysts claim in a new report.
In fact, always current borrowers who practice what is known as 'curtailing' – or paying down debts at a faster pace – are associated with a 43% lower default rate whenever they manage to pay down at least 1% of their outstanding principal over a 12-month period, said David Zhang, a managing director with Credit Suisse, who contributed to the firm's Global Securitized Products Weekly report.
Looking at the chart below, Zhang and Credit Suisse analysts suggest curtailing mortgage debt at a faster pace is a stronger indicator of long-term loan performance in the non-agency MBS segment when compared to FICO scores.
Curtailing trends are now occurring among borrowers who are both underwater and those who are simply trying to build equity in their homes, the report says.
The downside of curtailing is that a sudden pick up in principal payments can signal increased risk when the curtailing quickly ends after picking up. Still, those who curtail are considered safer credit risk bets than those who don't, even if they stop half-way through.
"On the other hand, borrowers who either slowed or entirely stopped curtailing after a year of curtailment could potentially be facing financial hurdles," Credit Suisse analysts explained in the report. "We clearly see this in prime, where these borrowers fared far worse – defaulting at a higher rate than borrowers who never curtailed."
Still, Credit Suisse believes curtailing is a significant metric and a tell-tale sign of future credit performance, with higher principal payments early on, suggestive of a borrower who has found a more stable financial position.
"Conversely, non-curtailing borrowers have either maintained their status quo (in which case they are less likely to default) or have found themselves in either a weaker financial position or have experienced an adverse life-changing event," the report said.
"This is not to say that borrowers not curtailing among the always current cohort have any less willingness or ability, but rather that, within this cohort is a greater subset of borrowers that might be on the brink of their first default."