According to Standard & Poor's Ratings Services' Housing Volatility Index (HVI), which calculates the volatility of housing in 331 metropolitan statistical areas (MSAs) and determines the probability of price declines in the event of an economic downturn, what went up may be coming down.

"The report is the first of its kind," says Standard & Poor spokesperson Adam Tempkin. "We are putting out a series of reports."

Standard & Poor is known as a "preeminent" provider of credit ratings, and for financial market indices as the S&P 500®. The company also does a lot of risk analysis, which is where the housing volatility index comes in.

The supply of homes is historically low (4.4 months - existing, 3.7 months - new) against a high of approximately 13 months -existing in 1983 and 12 months - new in 1974. Only 1999 existing homes were lower in supply, along with new home supply at two months on hand in 1975. Mortgage interest rates remain low to offset rising prices. Home prices are rising nationwide, albeit modestly in some areas. Debt burden is record, and incomes have not risen enough to beat inflation in years.

Simplicity, says the HVI report, is key to cutting through the contrary opinions of the market because it is based on statistical volatility. The report focuses on the house price volatility as reported in the quarterly OFHEO HousePrice Index. S & P analyzes the loss severity calculation and whether borrowers are at risk of default or would be able to refinance should interest rates rise. The HVI particularly considers loans that meet or don't meet the characteristics of greater risk.

For example, when including interest-only loans, S & P calculates an "adjustment" if the loan doesn't meet certain criteria. Theoretically, if the FICO score is greater than 695, there is no adjustment. If the FICO score is lower than 660, there is a 1.20 point adjustment to the loan's foreclosure frequency.

So the index basically measures lender risk for default as it relates to local housing.

Research shows that the MSAs with the sharpest gains over the past year are likely to suffer declines over the next two to three years in the event of an economic downturn, but not always.

In one year from June 30, 2003 to June 30, 2004, Las Vegas had the highest housing appreciation in the nation at 24.94 percent. Although local Realtors report some decline in demand, prices haven't appeared to suffer much beyond stabilization recently. According to S & P's HVI table, which illustrates housing declines over the next two to three years, Las Vegas isn't in the top 20 MSAs with the highest probability of decline.

Some areas of California appear volatile. Orange County housing experienced a 21.60 percent increase in a year, and S & P predicts it will be the sixth most likely MSA to have a market value decline. Ditto for Fresno, Los Angeles and Ventura. Yet San Diego didn't make the top 20 market decline list.

S & P believes that as interest-only borrowers reach the end of their loan periods before converting from low fixed rates to much higher adjustable rates, credit scores will decrease and defaults will rise.

More information is available in S & P's "Boom, Bubble or Bust? S & P's Housing Volatility Index Will Let You Know," dated December 10, 2004.

Published: December 16, 2004

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