NEW YORK - With home prices skyrocketing, Deutsche Bank Securities analysts warned that there is more of a downside risk in this cycle than at any other time in recent history at the investor gathering held here last week. Specifically, analysts expressed concern over California, which has seen a housing mega-boom' and is the epicenter of mortgage innovation.'
In her presentation, Karen Weaver, global head of securitization research at Deutsche Bank, noted that there hasn't been a year-over-year decline in the nationwide home-price index, and that, in aggregate, affordability - which is the key component in assessing the sector's viability - remains relatively high. While Weaver does not expect nationwide price declines, should declines occur, they would likely be limited to areas such as California. Moreover, "Even if we are at the peak, it will take well over a year to impact mortgage performance," Weaver added.
There are several arguments playing against those predicting a widespread bust. According to Weaver, aside from high affordability rates, she noted that traditionally, rising interest rates could be "taken in stride" as long as the increase is moderate -defined as under 250 basis points - and income does not stagnate. She added that housing behavior is unique because aside from being an asset it also has utility. In other words, homeowners do not need to and generally choose not to sell their homes in soft markets.
"We don't agree that we are about to see a bubble burst in U.S. housing," said Weaver. However, "but we are concerned about signs of irrational exuberance' much of it in California," she added, the state with nearly one quarter of all subprime mortgage exposure.
The California housing market "refuses to stabilize and therefore becomes harder to justify year after year," added Weaver, affordability in California has plunged, with five major Metropolitan Statistical Areas at their record lows.
Additionally, as a response to low affordability, the state has become a center for mortgage innovation. In fact, in 2004 alone, California subprime borrowers were three times as likely to take out an IO loan compared to those in other states. In addition to the loans themselves being riskier, Weaver said, they also put the general housing market at risk by driving up starter home' prices and leading to record-low home-equity levels. These loans also increase the number of financially marginal homeowners and the state's susceptibility to rising rates. "In a market where you cannot short an asset, marginal buyers can drive prices," Weaver said.
Data presented showed that for the eight largest California Metropolitan Statistical Areas, cumulative home prices have more than doubled in nominal terms, leading to a mega-boom' that is not comparable to previous cycles. "Some areas are so far beyond the fundamentals that a soft landing is less likely," Weaver warned. She also noted the adverse effect on underwriting standards. Some underwriters are starting to view subprime mortgages almost as thought they are bridge loans' - assuming that these mortgages are going to refinance and thus not stay in the pools for very long. The infiltration of this mindset is dangerous, especially if the market makes a turn for the worse, Weaver said.
For subprime mortgage investing, Weaver recommends moving up in credit, all else being equal, and looking at shorter WAL bonds on new issue subprime MBS. She also highlights the importance of seller-sevicers as "... the quality of their underwriting and servicing will be at least as important as housing market conditions," Weaver added. She also recommends synthetics as a way to go long older vintages while shorting 2005.
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