With California's home prices showing disturbing signs of a late 1980s-like bubble, analysts are now looking at how regional weakness could affect valuations in the MBS market, specifically the jumbo sector.
In a recent report, JPMorgan Securities analysts stated that California's strong housing market has in the past year become potentially unsustainable, characterized by the significant leverage seen in the late 1980s California bubble. For instance, the ratio between median home prices and median incomes rose to over 7.5 by 1990 - which was over twice the national average. As home prices dropped in the early 1990s, the ratio of price to income readjusted to roughly four. It has been steadily increasing from the mid-1990s and is now almost 7. Recent National Association of Realtors data showed prices for new California home sales decreased slightly, the only region to display a drop.
There is a considerable increase in leverage in California loans and buyers may be at the edge of affordability, JPMorgan analysts said, adding that roughly 70% of recent purchases in the state were financed through non-amortizing loans. Lenders are determining affordability not through the ratio of home price to income but by the ratio of home price to monthly cashflows. Analysts said that for the country, in general, the ratio of home price to income is less than 3.5, just slightly over the historical average. By contrast, in California, the multiple is 7, which is near its historical high. They said that the last time the ratio of home price to income was over 7, back in 1990, the California housing market imploded with home prices dropping roughly 10% to 15% from 1991 to 1994.
JPMorgan analysts acknowledge, however, that there is evidence supporting a less dramatic correction compared to the early 1990s. For instance, during the housing crash of the early 1990s, unemployment in California was soaring to almost 1.5% to 2% above the national average. In comparison, more recently, although the unemployment rate in the state remains above the national average, it has also been dropping in line with the country.
A weakening in California and northeast real estate along with strength in the remainder of the country might negatively impact the Jumbo market, said analysts. However, this would have relatively little effect on conventionals, and will likely be a positive for GNMAs. The risk to the Jumbo market - which California and, to a lesser degree, the northeast dominate - is from extension and the possibility that the recent drop in subordination levels may be reversed, resulting in possible downgrades.
A strong housing market and the refinancing wave, which have led to de-levering, have justified low subordination thus far. However, many triple-A Jumbo packages now have only 2.5% of subordination. Analysts noted that Jumbo fixed-rate discount speeds are now starting to dip versus conventionals, and are far less than GNMAs, slowing the pace of de-levering. Thus even though triple-A non-agency packages are trading at a historically cheap $1-02 back of conventionals, JPMorgan is still not favorable on the sector.
On the other hand, analysts are more comfortable with non-agency Alt-A collateral, which has higher subordination compared to prime product (as much as 5% for triple-A) and is usually more geographically diverse, especially for conforming Alt-A MBS.
Some analysts are more sanguine about California. Art Frank, head of mortgage research at Nomura Securities, said there are supply and demand factors that have pushed up California home prices. These factors are heavy overseas immigration -serving as an incremental source of housing demand - and a limited new supply of homes, due to restrictions on new developments, such as those of Marin County. These positive elements should continue supporting home prices. Even in a rising rate scenario, Frank expects merely a leveling off of prices in the state, or at worst, a slight decline.
Even with the growth of interest only collateral in the region, Frank remains relatively positive. Although severities tend to be higher for interest only loans and these mortgages get a larger payment shock when they reset, Frank said that the potential for higher losses in this type of collateral is compensated for by greater credit support. "I think the rating agencies require an appropriate amount of subordination," he said.
Douglas Duncan, chief economist at the Mortgage Bankers Association, said there is limited housing development in California because of restrictive legislation as well as the high cost and lack of land availability. The problem with supply being inelastic is that small changes in demand might trigger sudden home price fluctuations, said Duncan. Citing the Office of Federal Housing Enterprise Oversight House Price Index, California has been ranked in the top five among states with the highest level of house price appreciation. However, it was also ranked as among one of the states with the highest pricing volatility. "Volatility represents risk," Duncan said, adding that he is currently "watchful" of California real estate.
At present, however, the California housing market appears to be doing well with delinquency rates very low compared to the national average. Duncan also noted that in the 1980s, there were factors negatively affecting housing demand that are not present today, such as the retrenchment in defense expenditures that affected San Diego and San Francisco, and punitive taxes that led to the out migration of business and workers.
In terms of interest only loans being originated, the risk that observers are concerned about is whether borrowers are stretching their resources to the maximum to qualify for the loan just to be able to pay the interest portion of the loan. If so, Duncan said, when the principal portion is incorporated and the payment rises they may not be able to meet the payments. In this case, there may be an artificial support for current house prices since the borrower could not have qualified for the loan with a fully amortized payment.
However, he said that a majority of the borrowers who take out IO loans in California probably fall under three categories that are not considered risky. These are: first-time professional homeowners with expected high income appreciation, wealthy homebuyers who are using their homes for tax deduction purposes, and households that have significant, but irregular, bonus income.
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