Special Encore: U.S. Housing - Breaking Records not Bubbles

Original Release on June 16th, 2022: While many investors may be curious to know what other investors are thinking and feeling about markets, there’s a lot more to the calculation of investor sentiment than one might think.

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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. 

Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research. 

Jay Bacow: And on this episode of the podcast, we'll be discussing the path for both housing prices, housing activity and agency mortgages through the end of the year. It's Thursday, June 16th, at noon in New York. 

Jay Bacow: Jim, it seems like every time we come on this podcast, there's another record in the housing market. And this time it's no different. 

Jim Egan: Absolutely not. Home prices just set a new record, 20.6% year over year growth. They set a new month over month growth record. Affordability, when you combine that growth in home prices with the increase we've seen in mortgage rates, we've deteriorated more in the past 12 months than any year that we have on record. And a lot of that growth can be attributed to the fact that inventory levels are at their lowest level on record. Consumer attitudes toward buying homes are worse than they've been since 1982. That's not a record, but you get my point. 

Jay Bacow: All right. So we're setting records for home prices. We're setting records for change in affordability. With all these broken records, investors are understandably a little worried that we might have another housing bubble. What do you think? 

Jim Egan: Look, given the run up in housing in the 2000s and the fact that we,ve reset the record for the pace of home price growth, investors can be permitted a little anxiety. We do not think there is a bubble forming in the U.S. housing market. There are a number of reasons for that, two things I would highlight. First, the pre GFC run up in home prices, that was fueled by lax lending standards that really elevated demand to what we think were unsustainable levels. And that ultimately led to an incredible increase in defaults, where borrowers with risky mortgages were not able to refinance and their only real option at that point was foreclosures. This time around, lending standards have remained at the tight end of historical ranges, while supply has languished at all time lows. And that demand supply mismatch is what's driving this increase in prices this time around. The second reason, we talked about affordability deteriorating more over the past 12 months than any year on record. That hit from affordability is just not as widely spread as it has been in prior mortgage markets, largely because most mortgages today are fixed rate. We're not talking about adjustable rate mortgages where current homeowners can see their payments reset higher. This time around a majority of borrowers have fixed rate mortgages with very affordable payments. And so they don't see that affordability pressure. What they're more likely to experience is being locked in at current rates, much less likely to list their home for sale and exacerbating that historically tight inventory environment that we just talked about. 

Jay Bacow: All right. So, you don't think we're going to have another housing bubble. Things aren't going to pop. So does that mean we're going to continue to set records? 

Jim Egan: I wouldn't say that we're going to continue to set records from here. I think that home prices and housing activity are going to go their separate ways. Home prices will still grow, they're just going to grow at a slower pace. Home sales is where we are really going to see decreases. Those affordability pressures that we've talked about have already made themselves manifest in existing home sales, in purchase applications, in new home sales, which have seen the biggest drops. Those kinds of decreases, we think those are going to continue. That lack of inventory, the lack of foreclosures from what we believe have been very robust underwriting standards, that keeps home prices growing, even if at a slower pace. That record level we just talked about? That was 20.6% year over year. We think that slows to 10% by December of this year, 3% by December of 2023. But we're not talking about home prices falling and we're not talking about a bubble popping. 

Jim Egan: But with that backdrop, Jay, you cover the agency mortgage backed securities markets, a large liquid way to invest in mortgages, how would you invest in this? 

Jay Bacow: So, buying a home is generally the single largest investment for individuals, but you can scale that up in the agency mortgage market. It's an $8.5 trillion market where the government has underwritten the credit risk and that agency paper provides a pretty attractive way to get exposure to the housing outlook that you've described. If housing activity is going to slow, there's less supply to the market. That's just good for investors. And the recent concern around the Fed running off their balance sheet, combined with high inflation, has meant that the spread that you get for owning these bonds looks really attractive. It's well over 100 basis points on the mortgages that are getting produced today versus treasuries. It hasn't been over 100 basis points for as long as it has since the financial crisis. Jim, just in the same way that you don't think we're having another housing bubble, we don't think mortgages are supposed to be priced for financial crisis levels. 

Jim Egan: Jay, thanks for taking the time to talk. 

Jay Bacow: Great speaking with you, Jim. 

Jim Egan: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.