Early estimates for the first quarter indicate substantial downturns in a number of hot real estate markets, leading many to speculate as to how far prices will fall, and how severe losses in the price-sensitive subprime sector will be.

Annualized month-over-month home price appreciation in Bakersfield, Calif., at the end of the first quarter fell to negative 1.98% from 24.92% a year earlier, while Scottsdale, Ariz., fell to 15.3% from 33.5% and Miami, Miami Beach and Kendall, Fla. fell to 12.43% from 24.82%, according to monthly sales data tracked by research firm First American Real Estate Solutions. Nationally, home price growth in the first quarter - at about 5.2% - is the most pronounced deviation from the one-year rate in the past 15 years, according to JPMorgan Securities.

Market participants are beginning to agree that, indeed, the longest up cycle for housing since World War II is coming to an end. "I have been a skeptic of the market for some time now, and have been proven wrong thanks to the strong appreciation in the housing market," said one trader. But, he said, "We are already starting to witness real pressure in the housing market as rates are increasing and alternative cheap financing is running thin."

JPMorgan last week downgraded its outlook for subordinate subprime securities to "underweight" on the home price data - and said it sees an increased risk home price growth ending up in negative territory. "While this view has been often expressed in the market over the past several years, the difference now is that there is hard evidence and data to support that the big slowdown in housing that many have feared has finally arrived," JPMorgan analysts wrote last week. Even though second quarter home price appreciation is generally stronger than price gains experienced earlier in the year, the substantial slowdown in the first quarter compared to recent years indicates, "the slowdown in home price growth is accelerating and broadening in terms of the number of markets impacted," analysts said.

"Our view is that ... there is definitely cooling taking place," said Rui Pereira, a managing director in Fitch Ratings' RMBS group said last week. The pace at which prices will fall is in many cases a matter of anecdotal evidence because of the lag in availability of home price data, but most seem to indicate a slow descent.

Soft or hard landing?

Nomura Securities is predicting a more than 85% chance that the U.S. real estate market will hit a "soft landing" - a scenario which would bring about a 5% loss in the subprime sector, downgrades in some securities and the potential for wider spreads. The market has a 15% chance of a "hard landing," wherein home prices would decline by as much as 10% in some markets, subprime loans would see losses of 6% to 9%, spreads would widen significantly, and a number of triple-B rated tranches would experience losses.

While many subprime borrowers have pocketed extra cash by refinancing their homes amid an atmosphere of relatively high home price appreciation, lower price gains will likely put an end to that game, many say. It also means that positive performance in subprime home equity deals might be at a turning point. Some market players believe deal performance might have been masked by a preponderance of prepaying loans. Compared to last year, the relative strength of the Mortgage Banker's Association purchase application volume - which tracks the number of applications reaching mortgage lenders - is the lowest it has been in the 15-year history of the index, according to JPMorgan. Subprime mortgage volume reached a record high of roughly $520 billion in 2005, compared with a little more than $400 billion a year earlier and only $200 billion in 2003, according to Fitch. And, lower borrower expectations of future price gains will help fuel the lower prices. "Declining expectations will quickly feed into lower realized price growth," JPMorgan analysts wrote.

Housing data

According to data released last week, existing home sales in April fell to 6.76 million units, while new home sales surprised the market, rising 4.9% from March. Still, the supply of homes on the market reached the six-month mark for the first time since January 1998. Also, the supply of unsold new homes rose for the 12th straight month, said Stephen Stanley, chief economist at RBS Greenwich Capital.

Just as a low cost of funding drove lenders to reel in more and more buyers - sending the U.S. homeownership rate to an all-time high - higher interest rates and the subsequent declining sales will inevitably have the opposite effect. Lenders, such as ACC Capital Corp. are scaling back their operations as the cost of doing business has in some cases overwhelmed the profit they're getting from the loans they originate to subprime borrowers. A number of investors have speculated that underwriting standards have eroded, as lenders - who have introduced such products as the 40- and 50-year loan, as well as a number of interest-only and adjustable rate products - work to maintain origination volume.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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