Spotting shifts in markets.

Author:Kidd, Phillip E.

Hot purchase markets are worth their weight in gold this year, as refinance volume wanes. Prevailing mortgage rates in local markets can be used to plot those markets that are boiling hot, versus those only lukewarm or stone cold.

IN THE 1990s, AS INTEREST RATES FELL to their lowest levels in decades, refinancing activity swept origination volume upward from less than half a billion dollars in 1990 to more than $1 trillion in 1993. Swamped under a deluge of applications, originators and wholesalers did not have to worry about which markets were hot because they all were hot.

But now conditions are changing. More signs are appearing that the economy has broken out of its fits-and-starts pattern of the early 1990s and is now on a sustainable expansion track. Consequently, interest rates are expected to meander upward for the next several years.

Slowly rising rates will curb those borrowers who refinance at every drop of 25 basis points. While their disappearance will slash this type of production in some markets, it will not eliminate all demand for refinancing.

Improvements in jobs and incomes will permit more borrowers with less than exemplary credit histories to refinance. And borrowers with ARMs about to reset and balloon loans about to be called will take advantage of comparatively (to the 1980s) low rates to switch to fixed-rate loans.

In contrast to the decline in refinancing, production of mortgages for home purchase will explode in the next few years. Driving this phenomenal rise in loans for acquisition will be the huge number of younger boomers (under 35-years-old) who were priced out of the market during the 1980s. The rapid advance in home sales in the second half of 1993 is visible evidence of the enormous potential for mortgage originations from this unsatisfied demand.

As the economy advances and adds jobs and incomes in the next three years, younger boomers will aggressively enter the market to buy their first homes. Nevertheless, single-family origination volumes will fall from more than $1 trillion in 1993 to three-quarters of a trillion in 1996. The ratio of mortgages for home purchase to those for refinancing, however, will shift drastically from 40/60 now to 70/30 by 1996.

Eventually, most of the demand coming from younger baby boomers will be satisfied. Taking their place in the age group most inclined to make a first home purchase will be the considerably smaller baby bust generation (currently ages 18 to 29). When this shift occurs, housing sales will tumble abruptly, sliding to half their peak 1996 rate by the end of the decade. (A detailed explanation of this dramatic shift in demographics and its impact on housing demand appears in Chapter 5 of William W. Bartlett's The Valuation Of Mortgage-Backed Securities, Irwin Professional Publishing, 1994.)

Market-U.S. spread indicator

With the bulk of loan originations swinging away from refinancing and toward mortgages for purchase, suddenly not all local housing markets will be hot anymore. Some will be cooling, some lukewarm and some boiling, depending on the local economy's ability to generate job and income growth.

In the highly competitive mortgage business, originators and wholesalers during the rest of this decade will constantly be shuffling their resources among local housing markets to maximize volumes and profits and minimize delinquencies. Quickly, the methods for spotting market shifts will be dusted off and refined.

A simple, but often overlooked, tool is the market-U.S. spread indicator (spread indicator). This indicator represents the spread between the mortgage commitment rates in a particular metropolitan statistical area (MSA) minus the commitment rates for the United States over time.

The theory is that in expanding markets, where single-family mortgage demand exceeds local funding capabilities, interest rates rise above the national average. This creates a positive spread that means, on balance, that the local financial institutions are net sellers of loans to the secondary market.

In contracting markets, where local funding capacity exceeds single-family mortgage demand, interest rates fall below the national average. This creates a negative spread that means, on balance, the local financial institutions and individuals are net buyers of mortgage products from the secondary market.

The word "net" is crucial in understanding the spread indicator. Regardless of economic conditions in a market, mortgages are always being closed and some sold into the secondary market. A positive spread indicator identifies markets where growing mortgage demand is increasingly drawing funds from the capital markets to finance loans. In contrast, a negative spread signifies markets where a stagnating or shrinking mortgage demand is increasingly returning funds to the capital markets through the purchase of secondary mortgage products.

Supply-demand relationships are constantly in motion within individual markets. The spread indicator can't explain them; that requires analysis of economic and demographic data. Nevertheless, directional changes in the indicator do announce that something fundamental is happening to the supply-demand relationship in a market. Therein lies its value.

Usually, significant shifts take time to work out. Alerted by the spread indicator, however, users can place markets on a watch list. Then in an orderly fashion, they can adjust resources, revise pricing, alter underwriting guidelines and adjust collection efforts as markets lose or gain momentum.

Constructing the spread indicator

For this article, HSH Associates, a financial publishing company in Butler, New Jersey, supplied mortgage interest rates for 26 cities and a U.S. average for the period January 1989 to January 1994. Five years is normally long enough for substantial shifts in supply-demand relationships to occur several times within a local housing market.

HSH also provided 1991 and 1992 figures from the Home Mortgage Disclosure Act (HMDA)...

To continue reading