The Jumbo Market and House Prices

Spreads on Jumbo mortgages rose about 50 basis points in the past week. This is likely a market over-reaction: 80 percent LTV loans to borrowers with high FICO scores remain low risk mortgages.

But the impact on prices could be serious. Consider what happens when the cost of capital increases quickly by 50 basis points, from 6.5 to 7 percent. The cost of capital has gone up 7.7 percent. But lets say that expectations are for 2 percent house value growth. Then the cap rate for houses goes from 4.5 percent to 5 percent--an 11.1 percent increase. This translates into a ten percent decline in house prices (CF/5)/(CF/4.5) =4.5/5 = .9.

But this phenomenon could change expectations about futue house price expectations. As expectations worsen, the cap rate will rise further, and house prices will fall further. The next few months might be pretty ugly for the coasts.