If home prices level off, there will be a considerable impact on housing credit performance in the alternative real estate markets (ie. Jumbo, Alt-A and subprime products), according to a report released last week by UBS Warburg. The incident would "cause defaults to rise, and would boost loss severities to an even larger amount," wrote analysts at the firm.

Additionally, if housing appreciation stops, the cash-out phenomenon will slow significantly, something that could have a major impact on the overall economy.

"There does not need to be a decline in housing prices for credit performance to worsen," said Tom Zimmerman, ABS researcher at UBS.

All it takes, he said, is for the rapid appreciation of home prices seen in the last five years to slow to zero or to be limited to small percentage increases.

UBS researchers stated that the most apparent effect of the leveling off of home prices would be the sharp rise in loss severity. They explained that losses are a function of both the default rate and loss severity. It is possible to have high default rates and still have only a few losses if LTVs are low enough or if there is enough appreciation. With a 5.0% to 8.05% rise in home prices in the last six years, it is apparent that loss severities would have been at higher levels without those increases.

Analysts cited an example to show the effect of housing-price inflation on loss severity. If housing prices have risen 10% and loss severity on a liquidation was 20% without price inflation, the loss would have been about 30%. Of course this is only an approximation. The actual severity would be closer to 32.5%.

But will prices really level off?

Given the data analyzed, researchers at UBS believe that home prices are not in a bubble phase or near bursting. However, a strong case could be made for slower home price appreciation in the coming years. Historically speaking, periods of quick price appreciation have been followed by periods of below-average gains. This would actually mean a period of zero housing inflation in a low inflation environment.

With the slowing of the economy and unemployment rising, analysts stated that there could be a slowdown in the buying of big-ticket items, including homes. Because of these factors, analysts believe that the odds are for a leveling off of home prices in the coming years even without a housing "bubble."

UBS looked at home-sales volume, home price appreciation, real home-price appreciation, and housing affordability. In terms of home-sales volume, the researchers focused on existing home sales in their analysis as opposed to new home sales because existing home sales usually represent 83% of annual home sales in the U.S. On the other hand, new housing only comprises about 17%. In terms of home-price appreciation, analysts utilized the Freddie Mac price series since it is based on same home price changes, making it the most valid approach for calculating changes in home price. In contrast, National Association of Realtors data is only an average of all homes sold during a set time (the NAR series does not take into account changing composition of home sales, which may bias results).

UBS is currently studying the impact of housing prices on the loss severities and defaults, comprising differences that may exist in the Jumbo, Alt-A and subprime sectors. They are also going to examine how factors such as LTV, PMI and other variables can affect loss severity and defaults in the coming weeks.

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