U.S. mortgage rates are hovering around their highest levels in three years. Morgan Stanley Co-Heads of Securitized Products Research Jay Bacow and James Egan examine the forces keeping homeowners locked in and buyers priced out of the housing market.

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Jay Bacow: Jim, [we’re] getting a lot of questions about mortgage rates. We've been flying across the country talking to people. Are your arms tired?

James Egan: I'm hoping that all the extra flapping will give them just a little bit more definition so we can show them off as we talk about adjustable-rate mortgages.

Jay Bacow: And that is the definition of an ARM. Welcome to Thoughts on the Market. I'm Jay Bacow, co-head of Securitized Products Research at Morgan Stanley.

James Egan: And I'm Jim Egan, the other co-head of Securitized Products Research at Morgan Stanley

Jay Bacow: Today, we're here to talk about mortgage rates: how quickly they've moved, why they're here, where they might go, and what it means for the mortgage and housing market.

It's Thursday, October 8th, at 9am in New York.

Jim, as of this recording, the 10-year is over 5.3 percent. Rates haven't closed this high since 2002. The 30-year mortgage rate is around 7.5 percent. It’s about 150 basis points up since the beginning of February.

James Egan: Right. There have been quick moves in rates that has led to quick moves in mortgage rates. There are a lot of implications to that – from affordability, the housing market, mortgage market.

But when we think about the relationship between mortgage rates and interest rates, Jay, there's also a feedback mechanism there. Convexity hedging is what it's typically called.

Can you discuss the role that that might have played in this current episode? And what we should expect going forward?

Jay Bacow: Sure. So, the biggest driver of mortgage rates is Treasury rates. And Treasury rates are driven by a number of factors, and right now most people would point to inflation expectations and geopolitical concerns.

However, as Treasury rates go higher, homeowners that currently have a mortgage are less likely to move. And because they're less likely to move, that means that the average life of those mortgages that investors own gets longer.

And because mortgage investors typically want to keep their duration profile constant – as the average life of those mortgages gets longer, they are then going to need to either sell those mortgages or sell Treasuries, which will cause yields to go even higher.

And there's a bit of a feedback loop on that, which can pressure yields and mortgage rates even higher.

But what we would say is, at this point, we don't think there's a huge mechanism of that going through at this rate level. The average mortgage rate that homeowners have in America is almost exactly 4.5 percent. Obviously, they're less likely to move as rates go up. But they're 300 basis points out of the money.

So, from that point, it matters. But it didn't matter as much as when rates were a little lower. However, Jim, 7.5 percent mortgage rate – what does this do for housing affordability? Can you put that in context?

James Egan: Yeah. So, if we just think about this in terms of what a 7.5 percent mortgage rate implies for the monthly payment on the median-priced home, we are now up over $325 dollars if we use that 7.5 percent – assuming home prices are where they are today, incomes are where they are today.

That monthly payment's up over $325 from where we are at local lows in February; or where we were at local lows in February. That's a 17 percent increase, in terms of that monthly payment over just a seven-month period.

Jay Bacow: Alright, so, 17 percent increase over a seven-month period, that's kind of scary.

But as you and I have talked about in the past, given the fixed rate nature of the U.S. mortgage market, it's a tad misleading for the average homeowner in America.

So, what does this do to sales? Obviously, it's scary for new homeowners, though.

James Egan: Right. Look, you brought up the implications from a duration perspective, a convexity hedging perspective. All of this is just how the lock-in effect continues to have material implications for the housing market, for mortgage markets.

But yes, these affordability issues – not that bad for homeowners who have an average rate below 4.5 percent. That's not changing. Over 90 percent of the balance or count of mortgages, depending on how you want to look at it, in the United States remains fixed rate. Their payments aren't changing, right?

But the marginal home buyer, things are getting less affordable. I don't like to use the term demand destruction. I think that sounds a little bit too over the top here. But like we are seeing some of our higher frequency or more leading indicator demand metrics show a little bit of softening here.

Pending home sales, past two months, 3 to 5 percent down year-over-year. Purchase applications, which had been very strong, in September, they were down about 10 percent year-over-year. So, look, we were seeing a little bit of demand increases this year. We were up about 2 percent year-to-date through July.

It's a small increase off of a very, very low base. But we think you're going to see with rates at these levels, if we maintain these levels, is effectively the probability or any real ability of the market to escape to the upside from an activity perspective? That probability keeps coming down. And we're going to be stuck in this turnover, very range-bound, lowest level of sales as a percentage of the housing market in 40 years.

Jay Bacow: So really low activity, what does that do to prices? Is there some flow through? Is there relief coming?

James Egan: Look, as demand softens, the kind of first-order expectation or the heuristic should be that prices should soften as well. But again, lock-in effect; what we've actually seen is the rate of growth for existing listings at these levels has slowed. And it's slowed pretty materially.

That's actually led to home price appreciation accelerating over the past few months. We've gone from just 0.7 or 0.8 percent four months ago to 1.9 percent for the data that we just received. We think that that level is kind of sustainable here, and we're going to be between like roughly 2 percent, give or take, for the remainder of this year.

Now, you and I have both been mentioning the lock-in effect throughout the course of this. Yes, an overwhelming majority of the market is fixed rate right now. But the media, our conversations with clients, there's been a lot of discussion of potentially a growing share of adjustable-rate mortgages to kind of help the marginal homeowner with affordability.

What are we seeing in ARMs right now?

Jay Bacow: Okay. Yeah, so great question, and we are seeing a pickup in ARM issuance. If we look at the percentage of mortgages that were ARMs through the first half of this year and compare them to the percentage of ARMs in the first half of last year, it's increased by about 1 percent on aggregate issuance. It's went from about a little over 15 percent to a little over 16 percent.

And so, 1 percent increase is not a huge number by itself, but when we're talking about a little over $2 trillion of expected issuance in the course of the year across the entire mortgage market, this does help on the margin. And we do think, as we said in the past, that more uptake of ARMs would likely be a little bit of a positive solution to some of the affordability challenges.

But Jim, if people take out more ARMs, recognizing that most people only have two arms, should we be worrying about a repeat of the financial crisis and lending standards?

James Egan: So, this is a question that we get a lot when we start talking about moving away from fixed-rate mortgages. And the point that I want to stress; that we want to stress here, is not all ARMs are created equal…

Jay Bacow: Mine are stronger than yours?

James Egan: Sure, we'll go with that. But also, if we control for borrower characteristics, right? Credit scores, loan-to-value ratios, debt-to-income ratios, right? And then we compare performance of adjustable-rate mortgages to fixed-rate mortgages, 7-1 ARMs, 10-1 ARMs, they perform very much like fixed-rate mortgages.

It's really the short-reset ARMs, what we'll call affordability products. So, they only have 24-month or 36-month fixed periods. Those are what have historically showed a much higher rate of default and something that would get us a little bit more concerned about lending standards if those were the products we're talking about.

Thankfully, they're not right now. The ARM growth that we're seeing is in the 5-1, 7-1, 10-1 space. Those have historically, again, controlling for borrower performance, performed like fixed-rate mortgages. And so, we think that you can expand mortgage product into ARMs and do it responsibly.

Jay Bacow: All right. Jim, always a pleasure speaking with you.

James Egan: And always great speaking to you too, Jay. And to all of our regular listeners out there, thank you for adding us to your playlist. Let us know what you think wherever you get this podcast, and share Thoughts on the Market with a friend or colleague today.

Jay Bacow: Go smash that subscribe button.

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