With home price growth starting to revert back to more historical norms - increasing at a slower pace than in the earlier part of 2002 - mortgage analysts said that this would affect prepayment speeds going forward.

Last week, the Office of Federal Housing Enterprise Oversight (OFHEO) released its House Price Index for the third quarter, which stated that average home prices went up by only 0.84% in Q3 compared to the previous quarter's increase of 2.34%. The report also said that seven states, as well as 33 out of 185 Metropolitan Statistical Areas (MSAs), experienced a quarterly drop in home price growth.

Separately, the most recent Freddie Mac home price data implied a significant drop in home sales in 2003. Also, the Freddie Conventional Mortgage Price Index (CMHPI) for the third quarter reported that nationwide home prices increased by just 0.79%. This means only a 3.1% annualized growth - dramatically less than the 8.5% in the second quarter. Excluding the fourth quarter of 2001, this tepid third quarter 2002 increase was the weakest home price growth since the third quarter 1996.

Analysts from UBS Warburg cited the Freddie Mac data in a recent report, saying, "This is the first unambiguous sign that the housing market is slowing - and it's a strong one."

Researchers from UBS said that the 3% annualized home price appreciation is broadly consistent with their expectations going forward. They added that if rates remained unchanged, their regression model - which is based on home prices, home appreciation and mortgage rates - would imply that existing home sales should actually dip from 7.2 to 6.9 CPR in the first quarter of next year.

Analysts said that existing home sales, home price appreciation and prepayment speeds on discount coupons are all linked together. The main driver for existing home sales are homeowners who are moving into new homes because they are trading up, and these people usually trade up when the equity in their homes increases. The easiest way to increase the equity in homes is through home price appreciation. Therefore, a strong correlation has existed historically between home price appreciation and existing home sales and, in turn, a huge correlation between existing home sales and discount turnover speeds.

This is why with home price growth slowing down, home sales are also expected to decrease in the next quarter. What effect would this have on discount speeds?

"The impact on discount speeds should be magnified nearly threefold, implying decelerations of about three-fourth CPR," wrote UBS analysts. "When rates back up, we expect home price appreciation to soften even more."

Regional outlook

The OFHEO House Price Index also looked at regional performance and comparisons. The report showed that out of the seven states and 33 MSAs that experienced negative price growth over the third quarter, five states and 21 MSAs were found in the Midwest.

JPMorgan Securities analysts cited a significant regional divergence in the home price growth in the New England and the Pacific regions, with a 7.3% and 9% growth over the third quarter, respectively. They contrasted this with the Midwestern states, which experienced zero home price appreciation.

Though the data provided by the OFHEO is only for conventional loans, analysts from the firm interpreted the data in terms of what it means for Jumbo loans. They said that because Jumbo originations have a strong coastal bias, the slowing headline number on home price growth should not be applicable to Jumbo paper.

Researchers said that about 40% to 45% of Jumbo originations are California-based, with an additional 20% to 25% in the Northeast and New England regions.

"If Jumbo originations in a particular region mirror the home price appreciation for conventionals in the same region, then Jumbos may have appreciated at twice the pace for all conventionals in the third quarter 2002," they wrote.

Effects of the dip

Slower home price growth may impact MBS supply going forward, said David Montano, head of mortgage research at JPMorgan.

He said that they expect that a 3% to 4% home price appreciation rate would lead to a decrease in MBS net supply starting the second quarter of next year. This would likely mean having around $2 billion to $5 billion in net securities per month, which is much slower than what was observed in most of 2002. This could actually mean as much as a 75% decline in net supply.

In terms of credit considerations (for Jumbo subordinates), however, the decrease in home prices would not have as much impact because majority of the decline is coming from the Midwest, where there are relatively few Jumbos outstanding. Jumbos are considered more credit-sensitive than conventional product because they do not carry the implied government guarantee.

Since home prices are still growing in areas where there is a concentration of Jumbo origination, slowing home prices should not yet be a problem for subordinate Jumbo A investors. This is assuming that the same credit geographic that exists for conventionals in terms of home price appreciation also holds true for Jumbos.

Analysts said that weaker home price appreciation should also mean fewer cash-out refinancings down the line. However, this is not a problem currently for most homeowners, since price appreciation in their properties has already been figured in. So to have less price appreciation now than in the past should not dampen a borrower's incentive to do a cash-out refinancing.

Bear Stearns recently looked at the equity take-out that occurs during a refinancing event. Dale Westhoff, senior managing director at Bear, stated that about 50% of the refinancing transactions could be attributed to cash-outs.

"We presumably would see more cash-outs now than in prior refinancing waves," he stated. However, even if a significant number of borrowers are cashing out their equity, the replenishment rate has been much greater than the cash-out rate.

Westhoff explained that the decline in home price growth has been long overdue, as the home appreciation experienced in the past few years has been well above historical norms.

The housing market, he said, is looking good - with supply levels low, affordability high, and home price growth positive. He added that the average borrower has seen over 40% increase in home values the last five years.

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