S&P: Bursting of Bubble Shouldn't Sink MBS Market

Standard & Poor's expects the housing boom to slow down, but analysts at the rating agency do not expect to see a market crash.

Rather than a bursting bubble, they say that housing prices in the riskiest market may fall victim to a "slow leak" that could hurt the credit quality of subordinate mortgage-backed securities, but would likely leave the rest of most classes of MBS unscathed.

Except in the case of a recession, of course, the residential MBS market may take a much larger hit from the impact of a housing slowdown, according to S&P. Some $1.9 trillion of MBS have been issued since 1993, when mortgage refinancing activity fueled record loan origination activity.

S&P's analysis, which simulated the impact of a housing market decline, indicates that the most likely scenario is that only the lowest-rated classes of MBS would likely suffer downgrades if home prices fall.

Even bonds backed by subprime credit quality loans would fare "reasonably well," S&P said.

The simulation assumed a 20% decline in home prices over the next two years, including a 30% decline on the East and West Coasts, where home prices have risen most dramatically. The simulation assumed a less dramatic 10% decline in home prices in the middle of the country.

Economically, the simulation assumed that unemployment rose slightly and that GDP growth slowed, but not to the point of recession. S&P noted that the simulation explored an unprecedented event: falling home prices despite a reasonably strong and growing economy.

The study also assumed that short-term interest rates would fall during the study period, which would benefit borrowers with adjustable-rate-mortgages. As such, ARMs faced no greater risk than fixed-rate borrowers, because their monthly payments would be likely to adjust downward in the simulation.

S&P analysts said the results of the study are generally "reassuring," with several caveats.

In a conference call to discuss the simulation, S&P director Michael Stock said the analysis shows that non-investment grade bonds would sustain the most damage in a housing downturn. However, if a recession were to occur in conjunction with a 20% national decline in prices, he said even investment-grade bonds would probably suffer downgrades.

S&P chief economist David Wyss puts the simulation in perspective, noting that nationally, home prices are now at 3.2 times household earnings. That's up from a historical average of 2.6 times median earnings.

"This is unsustainable. It can't go on forever," Mr. Wyss said, noting that low interest rates have helped fuel the rapid rise in home prices.

For prices to return to the historical average ratio of price to median earnings would imply a 20% drop in prices nationally, he noted.

But some markets are clearly wildly divergent from the historical average of price to area median income. In San Diego, for instance, the median home price is more than 10 times the median income. In 10 cities, including New York, the ratio is above nine.

But interest rates aren't going down anymore, and they are probably going to rise, Mr. Wyss said. That will make current home prices unaffordable to many borrowers.

Mr. Wyss said that the most likely scenario for a correction in home values is for prices to stabilize and remain flat for a period of time.

But if there is a more sudden correction in home prices, the impact of a decline in mortgage credit quality on the economy as a whole may be more profound than it would have been in the past.

"Mortgages are now spread through the economy, with most of them held through securitization rather than by the issuing bank," Mr. Wyss noted.

SNAPSHOT: Median Income to Median Home Price

Current Ratio 3.2 Times Earnings

Historic Ratio 2.6 Times Earnings

Source: S&P

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