With mortgage rates at their highest level in 20 years, housing affordability may deteriorate to levels not seen in decades.

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Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-Head of Securitized Products Research here at Morgan Stanley.

Jay Bacow: And I'm Jay Bacow, the other Co-Head of Securitized Products Research.

Jim Egan: And on this episode of the podcast, we'll be discussing U.S. home prices. It's Tuesday, October 31st at 11 a.m. in New York. Happy Halloween.

Jay Bacow: Jim. Mortgage rates are close to 8%. They haven't been this high since the year 2000. Now, you've pointed out in this podcast before, home prices have been incredibly resilient. So what is this combination of mortgage rates being at the highs over the last 20 years versus resilient home prices mean for housing affordability?

Jim Egan: Well, not good. Now, one of the statements that you and I have made on prior episodes of this podcast is that affordability remains incredibly challenged. But at least throughout the first half of 2023, it really wasn't getting any worse. If mortgage rates stay at these levels, we can no longer make the second half of that statement. In fact, affordability deterioration would return to the most severe that we've seen in decades, 2022 experience notwithstanding.

Jay Bacow: Okay. But what does that mean for the housing market? You know, at first blush, it doesn't sound great, but we've done a lot of these podcasts, and the story that you're talking about sounds kind of similar to what we saw last year in 2022. Home sales and housing starts could fall, but home prices would remain protected as homeowners are effectively locked in to their current low mortgage rate and there's not a lot of for sellers.

Jim Egan: Those dynamics certainly continue to play a role in our thinking. But in our view, with mortgage rates at these levels, that requires us to think about both the short term impacts but also the longer term impacts if we were to stay here.

Jay Bacow: All right, Jim, you said shorter term first. So what do we think happens in the near future?

Jim Egan: Basically, what you just described, look, the immediate reaction to the recent climb in mortgage rates has been on the supply side. Existing listings have begun falling again, as of August we can now say that we have the fewest listings on record, controlling for time of year, the housing market is very seasonal and homebuilder confidence has also retreated. Now it increased in every single month of 2023 from January through July. In the past three months, it's down over 30% from that peak, and the NAHB attributes a lot of this u-turn to higher mortgage rates. At least when it comes to home prices, we think that the impact from these renewed decreases in the supply of homes is going to have a greater impact on prices than any decrease in demand. In fact, that did cause us to move our home price forecast a couple of months ago. We were flat at the end of this year and again, we're saying short term, this is October, the end of this year is pretty close. Our bull case was plus five. We're not moving all the way to that plus five, but we're moving towards that plus five from our 0% base case.

Jay Bacow: All right. So over the next few months, you're a little bit more constructive on home prices, but people own homes for many years. So longer term, what do you expect the outlook to be?

Jim Egan: Well, the answer there is, you know, more predicated on how long mortgage rates stay at these levels. We do think that a higher for a longer environment requires a different outlook today than it did in late 2021 and early 2022, and there are a number of reasons for that, but I think one of the bigger ones, Jay, is kind of the distribution of outstanding mortgage rates today. What does that look like?

Jay Bacow: The average outstanding mortgage rate today is roughly three and 5/8%. But if you look at the distribution of homeowners, because we spent basically all of 2020 and 2021 at really low mortgage rates and many homeowners were stuck in their house, they spent a lot of time refinancing. And so there isn't that many mortgages that have a much higher rate than that. And so if we look at, for instance, the universe of mortgages between 7% and 8%, that's less than 2% of the outstanding mortgages.

Jim Egan: And this is an important point, because not that many borrowers are falling out of the money with this move, we don't think that supply is going to see the sharp, sharp drops that we experienced throughout 2022. There's also some level of transaction volumes that need to take place regardless of economic incentive. If we look at home sales versus the stock of own homes is one example here. We're already at the lows from the great financial crisis. So instead of sharp declines in home sales moving forward, we think it's more accurate to describe a higher for a longer rate environment as more preventing sales from increasing going forward.

Jay Bacow: All right. So the sales outlook, I guess, feels a little better than the sharp drops that we saw last year. But what about home prices?

Jim Egan: If home sales were to remain at these levels, then we become even more reliant on the supply of for sale housing, staying at historic lows, or at least the lowest levels we have on record going back over 40 years, to prevent home prices from falling. As a scenario analysis, let's just say that inventory were to grow just 5% next year. For context, inventory was growing for May of 2022 through the middle of this year. If we just get 5% growth and that comes alongside zero increase in sales because of the affordability challenge, our model says that would lead to a drop in home prices by the end of 2024, that rounds to about 5%. But Jay, that's all predicated on where mortgage rates go from here. So are we staying at these levels?

Jay Bacow: The biggest driver of where mortgage rates go is where treasury rates are going to be. However, there's certainly a secondary component which has to do with the spread between where Treasury rates are and the spread where the originators can sell their mortgage exposure to investors. And that spread looks way too wide to us over the longer term. Now, you talked about short term versus long term. Short term, we're not really sure what happens to spread, longer term we do think that spreads will compress, which would bring mortgage rates lower.

Jim Egan: Surely at some point these levels become attractive?

Jay Bacow: Absolutely. And we think longer term, that point is now we're talking about owning a government guaranteed asset at about 6.75% yield that picks roughly 180 basis points the Treasury curve. That's not a level that things normally trade at. We think next year as the Fed cuts rates, vol comes down, the curve steepened and mortgages would tighten under that scenario. But near-term over the next couple of months, as you're talking through the end of the year, it's hard to have much conviction and there's risks certainly to further liquidity pressures and spread widening.

Jay Bacow: All right, Jim, it's always great talking to you.

Jim Egan: Great talking to you, too, Jay.

Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcast app and share the podcast with a friend or colleague today.

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