Value Commentary

Home Price Appreciation

The Federal Reserve Bank is predicting that the housing market will begin to cool and the rate of home price appreciation will slow down. As home price appreciation is a significant factor in mortgage prepayments, it is important to consider how this will affect the price of MBS. The Andrew Davidson & Co., Inc. Prepayment Model has a home price appreciation component and allows the user to adjust the forecast for long-term growth by altering the appropriate data files (confhpi.txt and nonconfhpi.txt). Confhpi.txt and nonconfhpi.txt contain historical values of home price indices for conforming and non-conforming homes, respectively. They also contain an additional entry that allows the user to input a long-term forecast for the rate of growth. By default this forecast is set to 4.5% annual growth, which is the historical average.

To analyze the sensitivity of prices to long-term home price appreciation, we lowered the growth forecast to 3.5% then raised it to 5.5% to see what impact this would have on the valuation of the basket of TBAs used for our weekly market analysis. The results are summarized in Table 1, below. The column marked HPI Duration shows the percentage change in price for a one percentage point rise or fall in the Home Price Index.

The largest impact on prepayment speeds occurs in the par coupons, which are currently in the 5% to 6% range. The prepayments of high premiums are not significantly affected. This is because home price appreciation drives cash-out refinancing, which has the largest impact on the slight-discount to moderate-premium sector. However, the price sensitivity of the par coupon sector tends to be lower than for the discount and premium sectors. This means that the HPI duration for pass throughs is very low across the board.

Perhaps more important is the effect of home price appreciation on IOs and POs, which are much more sensitive to prepayments than pass throughs. The results of this study are summarized in Table 2. It is easy to see that POs are much more sensitive to the HPI forecast than are pass throughs, and IOs are even more so. For most of the IOs, a one percentage point change in the HPI growth forecast will lead to about a one percent change in value.

In conclusion, your assumption regarding the future growth of home prices will be reflected >>>