Freddie Mac's Conventional Mortgage Home Price Index (CMHPI) reported last week that home values rose by an annualized rate of 4.8% in the third quarter, a figure that is almost flat relative to the previous quarter's revised annualized rate of 4.9%.

A UBS report noted that Freddie's latest home price data "paints a picture of steady, solid home price appreciation." If the current data presents an accurate and lasting picture, discount speeds should be quite robust in a selloff, added analysts. This is because home price appreciation drives housing turnover, with borrowers often trading up to a better house. Housing turnover, in turn, drives discount speeds.

"Now that mortgage rates are higher, we have to see in the next couple of releases whether home prices will continue to be robust," said Glenn Boyd, an analyst at UBS. "If home prices continue to be robust, that suggests that discount speeds would be robust as well."

In the report, Boyd wrote that there are two possible reasons why the next CMHPI report would show signs of strength.

The first is that Freddie has just improved its processing systems to lessen the downward biases in CMHPI data for the most recent quarter. Boyd explained that it usually takes 45 days after origination for a lender's loan file to get to Freddie, but it could take 60 to 75 days in a major refinancing wave. Because of this lag, the CMHPI data (before the changes) was often based on one month's data, although it was supposed to represent an entire quarter's equity growth. This caused CMHPI to understate home price appreciation in the most recent quarter. Though this downward bias was corrected in the following quarter, people failed to note that the prior quarter's number was revised, and instead focused on the current quarter's results. This could give the impression that house prices have not been accelerating as strongly as they have.

"This was particularly true in 2003,when refi volume exacerbated revision biases," wrote UBS. "Subsequent corrections reveal steady home price appreciation

in 2003, but these corrections get little media fanfare. Going forward, we expect upward revisions to be much smaller than historically."

Freddie s deputy chief economist Amy Crews Cutts said that before these changes, often the CMHPI would only incorporate data in the beginning of the quarter. "Where that comes from is not that house prices fundamentally change in the middle of the quarter," said Cutts. "It was that we were really observing monthly changes and pretending they were quarterly changes. When we added the extra month of data, what we did was reduce the amount of revisions that happen over time and that creates a much more stable CMHPI."

The difference is in the appraisal

New appraisals versus the use of dated ones also impacts the CMHPI data. UBS is optimistic that a shift toward new appraisals will push the index higher. In a refinancing wave, most of Freddie's repeat home prices are from refinancings. But a considerable percentage of refinancers with relatively young mortgages can avoid a new home appraisal by simply using the old one. In contrast, in a purchase market, the lack of an appraisal is not a problem, as borrowers have to go through one to buy a new house. In the recent refi boom, the effect of the lack of appraisal might have been more significant with 80% of origination tied to refinancings and only about 20% for purchase.

Freddie's Cutts explained that for non cash-out borrowers who refinanced in the last year - particularly during times of high volume - appraisals were usually waived. In these cases, a drive-by sufficed just to check whether the property concerned existed.

These new loans that were made without appraisals make it seem like home prices remained unchanged - resulting in a lower aggregate equity growth number than what actually prevailed. "Thus it seems likely that 2003 home price appreciation has been understated, in the Freddie Mac price index," UBS wrote.

It is still not clear how these non-appraised loans affect the numbers. If it turns out to be significant, the next quarter's CMHPI, which will have a higher percentage of purchase loans compared to refis, should show more robust home price appreciation, said UBS. The data would be "unpolluted" or "less polluted" by same-appraisal data problems.

"In a nutshell - technical difficulties with the Freddie Mac home price series may have resulted in understated equity growth in 2003," said UBS. "If so, the fourth quarter release should show continued strength, despite higher driving rates."

According to Cutts, the appraisal problems could be resolved by capturing the true mark-to-market value of the properties as the refinancing market gives way to purchase mortgages.

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