Navigating Convexity Hedging and Mortgage Affordability

While mortgage rates have come down, our Co-heads of Securitized Products Research say the US housing market still must solve its supply problem.

----- Transcript -----

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

Jay Bacow: And I’m Jay Bacow, the other co-head of Securitize Products Research.

Jim Egan: Along with my colleagues bringing you a variety of perspectives, today Jay and I are here to talk about the US housing and mortgage markets.

It's Wednesday, August 28th, at 10 am in New York.

Now, Jay, mortgage rates declined pretty sharply in the beginning of August. And if I take a little bit of a step back here; while rates have been volatile, to say the least, we're about 50 basis points lower than we were at the beginning of July, 80 basis points lower than the 2024 peak in April, and 135 basis points below cycle peaks back in October of 2023.

Big picture. Declining mortgage rates -- what does that mean for mortgages?

Jay Bacow: It means that more people are going to have the ability to refinance given the rally in mortgage rates that you described. But we have to be careful when we think about how many more people. We track the percentage of homeowners that have at least 25 basis points of incentive to refinance after accounting for things like low level pricing adjustments. That number is still less than 10 percent of the outstanding homeowners. So broadly speaking, most people are not going to refinance.

Now, however, because of the rally that we've seen from the highs, if we look at the percentage of borrowers that took out a mortgage between six and 24 months ago -- which is really where the peak refinance activity happens -- over 30 percent of those borrowers have incentive to refinance.

So recent homeowners, if you took your mortgage out not that long ago, you should take a look. You might have an opportunity to refinance. But, for most of the universe of homeowners in America that have much lower mortgage rates, they're not going to be refinancing.

Jim Egan: Okay, what about convexity hedging? That's a term that tends to get thrown around a lot in periods of quick and sizable rate moves. What is convexity hedging and should we be concerned?

Jay Bacow: Sure. So, because the homeowner in America has the option to refinance their mortgage whenever they want, the investor that owns that security is effectively short that option to the homeowner. And so, as rates rally, the homeowner is more likely to refinance. And what that means is that the duration -- the average life of that mortgage is outstanding -- is going to shorten up. And so, what that means is that if the investor wants to have the same amount of duration, as rates rally, they're going to need to add duration -- which isn't necessarily a good thing because they're going to be buying duration at lower yields and higher prices. And often when rates rally a lot, you will get the explanation that this is happening because of mortgage convexity hedging.

Now, convexity hedging will happen more into a rally. But because so much of the universe has mortgages that were taken out in 2020 and 2021, we think realistically the real convexity risks are likely 150 basis points or so lower in rates.

But Jim, we have had this rally in rates. We do have lower mortgage rates than we saw over the summer. What does that mean for affordability?

Jim Egan: So, affordability is improving. Let's put numbers around what we're talking about. Mortgage rates are at approximately 6.5 percent today at the peak in the fourth quarter of last year, they were closer to 8 percent.

Now, over the past few years, we've gotten to use the word unprecedented in the housing market, what feels like an unprecedented number of times. Well, the improvement in affordability that we'd experience if mortgage rates were to hold at these current levels has only happened a handful of times over the past 35 to 40 years. This part of it is by no means unprecedented.

Jay Bacow: Alright, now we talked about mortgage rates coming down and that means more refi[nance] activity. But what does the improvement in mortgage rates do to purchase activity?

Jim Egan: So that's a question that's coming up a lot in our investor discussions recently. And to begin to answer that question, we looked at those past handful of episodes. In the past, existing home sales almost always climb in the subsequent year and the subsequent two years following an improvement in affordability at the scale that we're witnessing right now.

Jay Bacow: So, there's precedent for this unprecedented experience

Jim Egan: There is. But there are also a number of differences between our current predicament and these historical examples that I'd say warrant examination. The first is inventory. We simply have never had so few homes for sale as we do right now. Especially when we're looking at those other periods of affordability improvement.

And on the affordability front itself, despite the improvement that we've seen, affordability remains significantly more challenged than almost every other historical episode of the past 40 years, with the exception of 1985. Both of these facts are apparent in the lock in effect that you and I have discussed several times on this podcast in the past.

Jay Bacow: All right. So just like we think we are a 150 basis points away from convexity hedging being an issue, we're still pretty far away from rates unlocking significant inventory. What does that mean for home sales?

Jim Egan: So, the US housing market has a supply problem, not a demand problem. I want to caveat that. Everything is related in the US housing market. For instance, high mortgage rates that put pressure on affordability -- but they've also contributed to this lock-in effect that has led to historically low inventory.

This lack of supply has kept home prices climbing, despite high mortgage rates, which is keeping affordability under pressure. So, when we say that housing has a supply problem, we're not dismissing the demand side of the equation; just acknowledging that the binding constraint in the current environment is supply.

Jay Bacow: Alright, so if supply is the binding constraint, then what does that mean for sales?

Jim Egan: As rates come down, inventory has been increasing. When combined with improvements in affordability, this should catalyze increased sales volumes in the coming year. But the confluence of inputs in the housing market today render the current environment unique from anything that we've experienced over the past few decades.

Sales volumes should climb, but the path is unlikely to be linear and the total increase should be limited to call it the mid-single digit percentage point of over the coming year.

Jay Bacow: Alright, and now lastly, Jim, home prices continue to set an all time high but there's the absolute level of prices and the pace of home price appreciation. What do you think is going to happen?

Jim Egan: We're on the record that this increased supply, even if it's only at the margins, and even if we're close to historic lows, should slow down the pace of home price appreciation. We've begun to see that year-over-year home price growth has come down from 6.5 percent to 5.9 percent over the past three months. We think it will continue to come down, finishing the year at +2 percent.

Jay Bacow: Alright, Jim, thanks for those thoughts. And to our listeners, thank you for listening.

If you enjoy the podcast, please leave a review wherever you listen, and share Thoughts on the Market with a friend or colleague today.