Whether you’re buying your first home, your 100th investment property, or facilitating such transactions as a real estate broker or lender, imagine having a crystal ball that reveals home prices two years from now?

There is no such crystal ball, of course. But PMI Mortgage Insurance Co. publishes a periodic risk index that helps consumers and real estate professionals gauge the odds that prices will fall in the top 50 housing markets.

The PMI U.S. Market Risk Index can help first-time home buyers decide whether that adjustable-rate mortgage, or ARM, with the low introductory teaser rate makes sense.

If home prices are going to keep going up, first-timers will have a better chance of being able to refinance their loan before their payments reset. But if prices are going to fall, they may want to consider a more conservative approach, buying only the house they can afford with a more traditional fixed-rate loan.

For homeowners who already have ARM loans and are facing resets, the risk index can be a wakeup call that they need to start thinking sooner rather than later about refinancing or a lender workout.

The Market Risk Index can also be a valuable tool for mortgage lenders, who may decide to tighten underwriting standards — requiring more loan collateral, for example — in markets where price appreciation may be headed for a reversal.

And the risk index can be a valuable tool for investors in mortgage-backed securities or real estate investment trusts, to ensure that their portfolios are diversified and not concentrated in a few high-risk markets.

The latest risk index, released Tuesday (see Inman News story), predicts that while some areas of the industrial Midwest that are experiencing economic problems could see price declines, the greatest risks are in areas where prices shot up the most during the boom.

Eleven of the 15 metropolitan statistical areas (MSAs) facing a 50 percent or greater chance of a price decline are in California and Florida, according to the summer 2007 latest Market Risk Index.

PMI doesn’t tell people how they should or shouldn’t use the company’s market risk index, but they do want them to understand how the numbers are derived.

To assess the demand for housing, the index looks at local trends in appreciation, unemployment, interest rates and affordability. The latest risk index incorporates several refinements intended to increase its predictive power in a market that’s in transition.

In addition to looking at recent trends in appreciation, the index now considers price volatility going back five years. And in rating the affordability of an area, the index now recognizes the fact that ARM loans can increase a purchaser’s buying power.

How it works

In the past, the risk index has looked at price acceleration and deceleration — the change in home-price appreciation from year to year. A deceleration in price appreciation doesn’t necessarily mean that prices are going down — just that conditions are changing.

The latest index, for example, shows Arizona’s Phoenix-Mesa-Scottsdale MSA had the greatest deceleration in price appreciation in the nation in the first quarter. Although prices still appreciated at 4.52 percent, that’s a far cry from the 37.33 percent achieved in the first quarter of 2006. So price appreciation for the Phoenix-Mesa-Scottsdale area decelerated by 32.81 percent — faster than anywhere else in the nation.

But that’s only a reflection in changes over the last year. The housing boom stretched for several years, and rapid and continued increases in the rate of price appreciation can increase the future risk of price declines, PMI analysts say.

In an effort to look at the trends over a lengthier period, PMI now calculates a volatility score, using the standard deviation of quarterly two-year price appreciation rates for the previous five years.

As a result, an MSA like Las Vegas-Paradise, Nev., which saw a sustained run-up in prices during the boom, now scores nearly as high as Phoenix for volatility, despite more gentle deceleration in home-price appreciation. Las Vegas, which saw price deceleration of 14.39 percent, was assigned a volatility score of 20.84, compared with 22.46 for Phoenix — the highest of MSAs.

All that saved Phoenix from the dubious distinction of earning the highest overall score on the risk index was that the MSA remains more affordable than California’s Riverside-San Bernardino-Ontario MSA, which earned an overall score of 652. That translates into a 65.2 percent chance that prices will be lower in two years, compared with a 64.6 percent chance for Phoenix and a 61.4 percent chance for Las Vegas.

The average risk score for the 50 largest MSAs was 346, or a 34.6 percent chance that prices on the whole will be lower in two years.

The affordability index, added 2 1/2 years ago, uses per capita income, house-price appreciation rates, and an estimate of the interest rates borrowers in the area will pay. While the index had previously relied on 30-year fixed rates to calculate affordability, it now uses a blended rate that includes 1-year ARM rates.

The blended numbers, as reported by the Mortgage Bankers Association for each MSA, allow the index to take into account the increased buying power — at least in the short term — of borrowers who use ARMs.

Foreclosures not in the recipe

While the model takes into account the potentially beneficial impact of ARM loans on affordability, it does not directly address other questions about the effect risky loans can have on housing prices, or delinquencies and foreclosures.

Many economists believe that much of the home-price appreciation during the boom was driven by easy access to credit and loose underwriting standards. That led some consumers to buy more home than they could afford, and attracted speculators who hoped to “flip” homes for a quick profit. Demand outstripped supply, driving up prices.

But the prevalence of ARM loans in an MSA can actually lower its score on the PMI U.S. Market Risk Index by boosting affordability. The index does not directly incorporate the impact of delinquencies and foreclosures — which can potentially hurt prices by increasing inventory — in its results.

But PMI is confident the index is more predictive than ever — in part because if risky loans do encourage speculation and drive up prices over time, that’s reflected in the new volatility score.

“The major thing we refined in the model was to add this concept of volatility,” Mark Milner, PMI Mortgage Insurance Co.’s chief risk officer told Inman News. “The volatility of the appreciation rate over the last five years is where we pick up the supply and demand signals.”

In other words, regardless of what’s creating the demand, it’s being measured in the risk index score.

Volatility also helps explain why the index predicts more moderate risks for price declines in parts of the Midwest, which have been hit hard by delinquencies and foreclosures.

“We certainly are aware of delinquencies and foreclosures, and while they are not directly taken into account in the model, keep in mind the model is predicting the probability of a decline two years from now,” Milner said. “We’re trying to give a longer view of what the risk is going to be in these markets, not what’s going to happen next quarter.”

So far, the index has proved a reliable predictor of market risk, Milner said. But like all models, it will probably require continued tweaks.

“We found the prior model was very well tuned to the high rates of appreciation from 2002 to 2006, while the new model is tuned to the changing market we’re in now,” Milner said.

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