By the Numbers

Finding opportunities if home prices fall

| January 27, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Although Amherst Pierpont sees home prices as unlikely to fall this year, many forecasts anticipate declines of 5% to 10% or more over the next year or two. Borrowers refinanced their mortgages less often after home prices dropped during and after the 2008 financial crisis, and that could happen if home prices start to decline again. Cash flows on loans with a high loan-to-value ratio should stabilize if home prices fall since neither Fannie Mae nor Freddie Mac currently will refinance loans with an LTV above 97%. Those pools should offer substantial prepayment protection as long as the GSEs continue to decline high LTV refinances. Generic pools are more sensitive to changes in home prices than pools with other forms of prepayment protection and may outperform loan balance and low FICO specified pools if home prices fall. And reverse mortgages, although a small part of the market, should prepay slowly if home prices decline.

Loans with high loan-to-value ratios are very sensitive to changes in home prices (Exhibit 1). Each chart compares loans with different original loan-to-value ratios but similar amounts of cumulative home price appreciation or depreciation. Loans that start with LTV≤60 are fairly insensitive to changes in home prices; for example, the S-curve peaks at roughly 50 CPR if home prices increase more than 5%, and peaks at roughly 45 CPR if home prices fall more than 15%. A loan with an original LTV between 95% and 97% also peaks at roughly 50 CPR if home prices increase more than 5% (although much of that jump occurs when home price increase more than 15%), but peaks at only 25 CPR if home prices were to fall more than 15%.

Exhibit 1. Borrowers struggle to prepay when current LTVs climb too high

Includes loans in 30-year fixed rate pools, TBA-eligible and conforming jumbo. Loans are 6 to 60 WALA, FICO≥700, original loan size between $200,000 and $400,000, and owner-occupied. Performance from January 2006 to present.
Source: Fannie Mae, Freddie Mac, Amherst Pierpont Securities.

However, right now high LTV pools offer even more protection than the charts indicate. Fannie Mae and Freddie Mac stopped refinancing loans that move higher than 97% LTV due to conflicts with the final rule for qualified mortgages. That should make it extremely difficult for these borrowers to refinance. Mortgages originated in the latter half of 2022 and in 2023 with LTVs close to 97% are very susceptible to modest amounts of home price depreciation.

The home price depreciation scenarios are dominated by the post-financial crisis era. Initially underwater borrowers were locked-out of refinancing. In early 2009, Fannie Mae and Freddie Mac introduced refinance programs for these borrowers, typically referred to as the Home Affordable Refinance Program (HARP). The first iteration was not very successful, but revisions that took effect in early 2012 allowed many underwater borrowers to refinance. The S-curves therefore show a blend of the two environments.

More recently, S-curves steepened during the pandemic. This may be due to a combination of high home price appreciation and greater use of appraisal waivers by Fannie Mae and Freddie Mac. However, if home prices fall, it is possible that the GSEs would scale back the use of waivers for underwater borrowers. Therefore, it is plausible that S-curves could flatten considerably if home prices fall.

Pools of loans with smaller loan amounts do not benefit as much as pools of larger loans when home prices fall (Exhibit 2). Smaller loans typically refinance more slowly but turnover more quickly than larger loans. But smaller loans do not refinance much slower in an environment with falling home prices and low interest rates. The smallest category shown, “LLB” loans with balances no more than $85,000, peak around 20 CPR regardless of the amount of home price appreciation. But the largest category shown—loans between $200,000 and $400,000—slows from nearly 60 CPR in a positive HPA environment to roughly 40 CPR if home prices fall sharply. In a discount environment everything slows, although the smaller loans retain the advantage of faster speeds. Higher balance loans have more to gain if home prices fall, which implies that loan balance pay-ups should drop if home prices fall.

Exhibit 2. Larger loans gain more convexity if home prices fall

Includes loans in 30-year fixed rate pools, TBA-eligible and conforming jumbo. Loans are 6 to 60 WALA, FICO≥700, original LTV≤80, and owner-occupied. Performance from January 2006 to present.
Source: Fannie Mae, Freddie Mac, Amherst Pierpont Securities.

Credit stories also show that higher credit loans stabilize more when home prices fall (Exhibit 3). The highest-credit loans refinanced nearly 20 CPR slower in the lowest home price scenario compared to the highest. That difference was roughly 10 CPR for the lowest-credit curve. If home prices were to fall, and TBA pools add more convexity than low FICO specified pools, then FICO pay-ups should fall.

Exhibit 3. High credit loans gain more convexity if home prices fall.

Includes loans in 30-year fixed rate pools, TBA-eligible and conforming jumbo. Loans are 6 to 60 WALA, original LTV≤80, original loan size between $200,000 and $400,000, and owner-occupied. Performance from January 2006 to present.
Source: Fannie Mae, Freddie Mac, Amherst Pierpont Securities.

Reverse mortgages also provide an opportunity if home prices fall, especially HECM IO bonds. Most reverse mortgages are floating rate loans, so borrowers have little incentive to refinance to save on financing costs. However, home prices and interest rates can affect how much a person can borrow against their home. A borrower can get a larger loan if home prices increase or if interest rates fall, and home prices typically have more influence than interest rates. If home prices fall, many borrowers will have no reason to refinance. Record high home price appreciation and record low interest rates pushed HECM speeds to new heights during the pandemic. Falling home prices, especially coupled with high interest rates, should slow speeds considerably. This benefits investors in HECM IOs. It’s a small market, but worth exploring for investors with conviction that home prices will fall.

Brian Landy, CFA
blandy@santander.us
1 (646) 776-7795

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