Mortgage credit risk modeling has evolved slowly in the last few decades. While enhancements leveraging conventional and alternative data have improved underwriter insights into borrower income and assets, advances in data supporting underlying property valuations have been slow. With loan-to-value ratios being such a key driver of loan performance, the stability of a subject property’s value is arguably as important as the stability of a borrower’s income.
Most investors rely on current transaction prices to value comparable properties, largely ignoring the risks to the sustainability of those prices. Lacking the data necessary to identify crucial factors related to a property value’s long-term sustainability, investors generally have little choice but to rely on current snapshots. To address this problem, credit modelers at RiskSpan are embarking on an analytics journey to evaluate the long-term sustainability of a property’s value.
To this end, we are working to pull together a deep dataset of factors related to long-term home price resiliency. We plan to distill these factors into a framework that will enable homebuyers, underwriters, and investors to quickly assess the risk inherent to the property’s physical location. The data we are collecting falls into three broad categories:
- Regional Economic Trends
- Climate and Natural Hazard Risk
- Community Factors
Although regional home price outlook sometimes factors into mortgage underwriting, the long-term sustainability of an individual home price is seldom, if ever, taken into account. The future value of a secured property is arguably of greater importance to mortgage investors than its value at origination. Shouldn’t they be taking an interest in regional economic condition, exposure to climate risk, and other contributors to a property valuation’s stability?
We plan to introduce analytics across all three of these dimensions in the coming months. We are particularly excited about the approach we’re developing to analyze climate and natural hazard risk. We will kick things off, however, with basic economic factors. We are tracking the long-term sustainability of house prices through time by tracking economic fundamentals at the regional level, starting with the ratio of home prices to median household income.
Economic Factors
Housing is hot. Home prices jumped 12.7% nationally in 2020, according to FHFA’s house price index[1]. Few economists are worried about a new housing bubble, and most attribute this rise to supply and demand dynamics. Housing supply is low and rising housing demand is a function of demography –millennials are hitting 40 and want a home of their own.
But even if the current dynamic is largely driven by low supply, there comes a certain point at which house prices deviate too much from area median household income to be sustainable. Those who bear the most significant exposure to mortgage credit risk, such as GSEs and mortgage insurers, track regional house price dynamics to monitor regions that might be pulling away from fundamentals.
Regional home-price-to-income ratio is a tried-and-true metric for judging whether a regional market is overheating or under-valued. We have scored each MSA by comparing its current home-price-to-income ratio to its long-term average. As the chart below illustrating this ratio’s trend shows, certain MSAs, such as New York, consistently have higher ratios than other, more affordable MSAs, such as Chicago.
Because comparing one MSA to another in this context is not particularly revealing, we instead compare each MSA’s current ratio to the long-term ratio for itself. MSAs where that ratio exceeds its long-term average are potentially over-heated, while MSAs under that ratio potentially have more room to grow. In the table below highlighting the top 25 MSAs based on population, we look at how the home-price-to-household-income ratio deviates from its MSA long-term average. The metric currently suggests that Dallas, Denver, Phoenix, and Portland are experiencing potential market dislocation.
Loans originated during periods of over-heating have a higher probability of default, as illustrated in the scatterplot below. This plot shows the correlation between the extent of the house-price-to-income ratio’s deviation from its long-term average and mortgage default rates. Each dot represents all loan originations in a given MSA for a given year[1]. Only regions with large deviations in house price to income ratio saw explosive default rates during the housing crisis. This metric can be a valuable tool for loan and SFR investors to flag metros to be wary of (or conversely, which metros might be a good buy).
Although admittedly a simple view of regional economic dynamics driving house prices (fundamentals such as employment, housing starts per capita, and population trends also play important roles) median income is an appropriate place to start. Median income has historically proven itself a valuable tool for spotting regional price dislocations and we expect it will continue to be. Watch this space as we continue to add these and other elements to further refine how we measure property value stability and its likely impact on mortgage credit.
[1] FHFA Purchase Only USA NSA % Change over last 4 quarters
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