Though recently released home price appreciation numbers were disappointing, experts believe they do not indicate a slowing housing market but rather reflect the volatility inherent in quarterly data.
Last week, both Freddie Mac and the Office of Federal Housing Enterprise Oversight (OFHEO) released home price growth figures for the first quarter. They showed similar results.
In its Conventional Mortgage Home Price Index, Freddie said that home values increased 8.5% annually (from 1Q03 to 1Q04), rising from 7.2% from the prior year. In contrast, quarterly growth rates showed a considerable decline compared to the previous quarter. In 1Q04, home values rose by an annualized rate of 5.6% nationally while the 4Q03 annualized growth was revised upward to 17.9%.
Meanwhile, OFHEO, in its House Price Index (HPI), said that average home prices in the country rose by 7.71% from 1Q03 through 1Q04. However, the quarterly appreciation rate is almost 3 percent less versus the revised 3.71% rise in the fourth quarter of last year. Appreciation for this quarter was 0.96%, or a 3.84% annualized rate, which is the first quarterly appreciation rate less than 1% since the second quarter of 1998.
Freddie Mac Deputy Chief Economist Amy Crews Cutts said that, despite the quarterly numbers, she still expects strong growth going forward. She added that quarterly numbers are usually volatile because they are influenced by variety of factors, such as the ratio of refinancing to purchase loans. In 4Q03, there was a dramatic drop in refinance activity as purchase loans became more popular. Since purchase loans are mark-to-market and reflect the true value of the property, this caused a surge during the home price index in the fourth quarter. The elevated refinancing activity that had happened before the fourth quarter also understated home prices because refinance borrowers do not usually have to get fresh appraisals (which the Freddie house price index is based on).
Echoing Crews Cutts, OFHEO Chief Economist Patrick Lawler said, "We tend to place a little more emphasis on the annual house appreciation number." He noted that the most recent quarter's numbers are the most susceptible to revision and added that one quarter's change doesn't necessarily indicate a trend.
Freddie's Crews Cutts expects house prices to grow anywhere from 6% to 8% year-over- year. "I think that's a reasonable range," she said, adding that all the positive fundamentals are still in place. "We have more jobs coming in, interest rates are low - even though they are not at rock-bottom - and housing remains a very good investment relative to other assets." In addition, there is a strong demand for second homes, she stated.
Going forward, Crews Cutts expects the housing market to continue growing, particularly as baby boomers reach their peak homeownership years and their children start to buy their own homes. She also expects second quarter results will remain strong because it would reflect the very low cost of mortgage credit in March, which was the start of the home buying season.
However, in two or three years, higher interest rates and the improved stock market compared to real estate will probably slow appreciation, Crews Cutts said.
Impact on prepayments
If the most recent quarterly slowdown in house prices becomes a trend, mortgage-backed analysts believe the impact on prepayments will be quite modest. Art Frank, head of mortgage research at Nomura Securities, said that there is a modest, positive correlation between discount prepayment speeds and homeowners' equity. This is because borrowers with significant equity in their homes often cash out, even without an interest rate incentive, due to the favorable tax treatment given mortgage debt relative to other liabilities. There is also a modest correlation between equity in the home and the propensity of homeowners to shop around. In both of those categories, a slowing of appreciation will probably cause a slight deceleration in discount speeds.
Frank added that a slowdown in home prices would affect slight premium speeds as well. This does not apply to high premiums because people can do a straight rate reduction refinancing without taking out equity even though there is no equity buildup.
The slowdown is probably a little more important on the credit side, said Frank. A prolonged slowing of house prices might lead to greater losses on private label MBS deals. "Of course, an improving employment picture will tend to cut the other way," said Frank. "But all else being equal, slowing house appreciation by itself is slightly negative for the credit quality of private label mortgage-backed securities."
Other analysts expect that the overall credit quality of mortgages will improve with job growth. However, Ohio and other states that are dependent on the manufacturing industry will continue to suffer because manufacturing jobs are not coming back nearly as quickly. There is also the concern that mortgage lenders might start reducing their criteria to be more competitive.
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