U.S. home price gains have demonstrated deceleration in the past few months as the shock to mortgage rates earlier this year reverberates through the housing market. Housing-related macroeconomic and demand factors have not resulted in broad reversals of home price appreciation (HPA). Furthermore, recent Federal Housing Finance Agency (FHFA) data show positive HPA growth during the second quarter. Unusually high inflation has rendered wage growth negative in real terms, despite historically strong nominal gains. Because these factors have impacted the affordability metric that S&P Global Ratings considers in its analysis of housing over/undervaluation, we now view U.S. home prices as approximately 20% (compared to our prior assessment of roughly 15%) overvalued at the national level. At a regional level, the proportion of overvalued metropolitan statistical areas or divisions (which we broadly refer to as MSAs) has crossed over the 90% mark and is now more than 93%, up from 88% as of our last assessment (see "Housing Overvaluation Trend Continues: What It Means For U.S. RMBS," published April 5, 2022).

We view home prices as overvalued or undervalued based on how much the price-to-income (PTI) ratio for a specified region (e.g., MSA or state) is above or below its long-term average. Our regional inputs are the FHFA price index (which increased approximately 10% from the fourth quarter of last year to second quarter of this year) and income per capita.

While in our prior over/undervaluation assessments we used a 15-year average to represent the long-term trend, the update described herein is based on the 20-year average. With the passage of time, the 15-year time series look-back window omits periods that we view as meaningful for the historical norm. In addition to retaining these critical periods, the 20-year average better reflects the deceleration in home price appreciation we have already observed in the data (see "Changing U.S. Home Price Trajectories Signal Cooldown," published Sept. 15, 2022).

Given the directional movements of HPA in certain regions and the overall deceleration at a national level and across various states (see charts below), overvaluation for the U.S. may be peaking. It's worth noting that we estimate the U.S. to have been overvalued by nearly 20% in 2005, only a few years before the housing market underwent a severe correction during the Global Financial Crisis. This further suggests that national housing overvaluation may have reached a turning point.

Chart 1

On Oct. 14, 2022, we updated our over/undervaluation measures, as well as the FHFA index inputs using second-quarter 2022 data. We use these values as they relate to certain U.S. residential mortgage-backed securities (RMBS) in our loan evaluation and estimate of loss system (LEVELS) model (see "LEVELS Model For U.S. Residential Mortgage Loans," published Aug. 5, 2019), which provides loan- and pool-level calculations of default likelihood (foreclosure frequency), loss given default (loss severity), and loss coverage. Depending on the pool diversification and location of the underlying mortgaged properties, overvaluation means our loss severity assumptions will tend to be higher (because a greater correction in home prices could occur under adverse scenarios). However, since our property value index now reflects second-quarter 2022 FHFA data, the indexed valuation will generally be higher, depending on when the valuation was performed and given the HPA between the fourth-quarter 2021 and the second-quarter 2022.

Housing Is Now Roughly 20% Overvalued Nationwide

While we believe housing is about 20% overvalued across the U.S., there is a substantial degree of regional variation, and a skew toward overvaluation in terms of the number of states and MSAs, and the extent of the overvaluation (see charts 2 and 3). However, the recent mortgage rate increases have already softened HPA, with both the S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index and FHFA indices declining in July. According to the October 13 Freddie Mac survey, the average 30-year fixed-rate mortgage rate is 6.92% with 0.8 fees/points--a year-over-year increase of almost 400 basis points.

Chart 2

Chart 3

The Most Over/Undervalued MSAs

There are still certain MSAs that have much higher overvaluations than the 20% national average. Chart 4 shows the 10 most overvalued and undervalued MSAs, and the distribution of over/undervaluation for 399 MSAs (based on our latest assessment) for use in evaluating mortgage pools and corresponding U.S. RMBS. Previously, we assessed 88% of MSAs across the country as being overvalued. That portion has increased to roughly 93%. Idaho continues to contain three of the top 10 overvalued MSAs, with the Boise region having the highest overvaluation level at 75%. Florida and Texas also have multiple overvalued MSAs in the top 10.

Chart 4

The Impact On Residential Mortgage Pools

Our over/undervaluation measure provides information about affordability in terms of deviations from a long-term average. Assuming the long-term average represents a steady state, overvaluation could influence how much property prices decline under certain scenarios. To account for this when rating certain U.S. RMBS, our assessment of over/undervaluation applies to our market value decline (MVD) assumptions when calculating the loss severity on a loan, based on our criteria (see "Methodology And Assumptions For Rating U.S. RMBS Issued 2009 And Later," published Feb. 22, 2018).

Under a 'AAA' rating stress, we assume that (for a given region) 50% of the overvaluation amount of a mortgaged property will factor into the MVD, with a corresponding value of 20% at a 'B' rating level. At the national level (assuming a 20% overvaluation), our 'AAA' MVD assumption is now approximately 55%, up from approximately 53% (when we assessed the national overvaluation at approximately 15% in April 2022). This assumes that under a 'AAA' rating stress, the additional decline in a property's value would reduce the property's liquidation proceeds by approximately 10% (compared to a market at equilibrium), and correspondingly, increase the loss severity assumed for a given loan. Compared to our last assessment of overvaluation, the 'AAA' decline in property value would be roughly 2% more.

The significant rise in home prices has resulted in both an increase in our general overvaluation assessment and an update to the FHFA index we use for properties with valuation dates before second-quarter 2022. When indexing property values, we apply 50% of cumulative upward movements and 100% of cumulative downward movements, based on our criteria. Higher property values resulting from this indexation could reduce the probability of defaults and temper loss severities. Overall, we believe the credit impact of high HPA and overvaluation levels on U.S. RMBS will depend on the geographic distribution of the mortgage pools, as well as the valuation dates of the properties backing the loans in the pools.