Thanks to the surge in mortgage rates, we've seen a historic collapse in mortgage affordability. New homebuyers are facing a massive sticker shock relative to what they could have paid just six months ago. So does this mean that house prices are due for a crash? On this episode of Odd Lots, we speak with Morgan Stanley housing strategist Jim Egan about what comes next. Egan argues that while high mortgage rates will discourage buyers, there won't be a significant unlocking of supply, since very few people will be forced to sell. It will be housing activity that sees the biggest change. This transcript has been lightly edited for clarity.
Points of interest in the pod:
How unusual is the housing market right now — 3:55?
Will house prices crash as rates rise? — 5:40
The lock-in effect in housing — 8:16
On credit availability — 10:46
The importance of inventory — 14:04
Will more homes get built? — 18:04
The role of baby boomers in US housing — 21:48
Could we see big price declines? — 25:15
How do higher rates feed into mortgages? — 28:20
Is anyone refinancing now? — 21:13
What happened to MBS buyers? — 33:28
What is household formation? — 26:57
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Tracy: (00:09)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:15)
Joe, there's nothing better than a good chart.
Joe: (00:18)
What chart do you have for us today? What chart are you gonna ask listeners to visualize in their mind since they can't actually probably like look at it right now? What, what chart should they be thinking about?
Tracy: (00:29)
Actually I have a bunch in mind. There are some extreme charts at the moment, given everything that's been happening with markets. I'm thinking in particular, you know, bond market volatility, what we saw with sterling and gilts very recently. But if you're looking for the most interesting charts at the moment, I gotta say I really think the housing market and the mortgage market are where it's at.
Joe: (00:51)
I completely agree with you. And you know, look, the Fed is raising rates to slow down the economy to beat inflation, but the number one sector of the economy that's most sensitive to rates, very directly, is housing. And so you just see some insane charts. We've been posting a bunch, but if you look at the price of a new 30-year mortgage, it’s just through the roof compared to six months ago. So many things like that. And you know, housing is so crucial to the overall economy. Everyone wants to buy one or wants to live in one. And what does it mean when these numbers are moving so fast, so hard?
Tracy: (01:27)
Right. Well, everyone also has an opinion on where housing is going, but you know, you mentioned a couple of those charts. You can look at pretty much anything, like the pure acceleration in mortgage rates has been unprecedented. The spread between mortgages and the 10-year US Treasury is now at a record. Housing affordability’s at a record low. There are so many you can choose from, but it really feels like given the unusualness of the situation and what we're seeing in some of these charts, it feels like there's a lot of uncertainty. So yes, everyone would expect higher interest rates to have a negative impact on the housing market. But we've also been talking about how there's low inventory and you know, there's a structural need for more housing in the US, so maybe things are different this time.
Joe: (02:14)
It's a really weird market because, you know, I think everybody is still kind of scarred from the great financial crisis. And you see these huge moves and you're like, well aren't house prices, don't they have to fall off a cliff? And yet if no one is forced to sell, what's gonna happen? Is the housing mortgage just gonna go away? Like no transactions except for people who, you know, get divorced or have to move or something like that. Seriously, it seems like a possibility. So much weirdness, you know, pull up a chart of like how many people are refinancing their mortgage. I mean it's basically the closest thing you find to a zero in a chart. Like no one is refi-ing with mortgages at 7% or whatever.
Tracy: (02:51)
I thought you were gonna mention the Reits, which is another good chart as well. So there are big questions about this market. And the other thing going on is you have a lot of people talking about market structure issues. So how mortgage rates are actually set, what's going on in the market for mortgage-backed securities. A lot of people have been saying, ‘Oh, you know, it's broken. There's something going on.’ So I am very pleased to say we are going to get into all of these issues or at least try to, because there is a lot of uncertainty, and we really do have the perfect guest.
Joe: (03:22)
Let's do it. I'm really excited. I have so many questions. Let's get going.
Tracy: (03:26)
Okay. We are going to be speaking with Jim Egan. He is Morgan Stanley's US housing strategist and does some great research on all of these topics. So Jim, thank you so much for coming on!
Jim: (03:37)
Thank you so much for having me. It's an honor to be here.
Tracy: (03:40)
So maybe just to begin with, we should talk about, is this environment that unusual? You know, you've been analyzing US housing for a very, very long time. When you look at what's going on today, how remarkable is it to you?
Jim: (03:55)
I would say that a lot of these statistics that we use to forecast things like housing activity, and by that we mean home sales or housing starts as well as home prices, are at levels that we either haven't seen before or if we've seen them, we haven't seen them for decades. I think you've already mentioned a few of the pretty important aspects of this. When we think about the housing market and taking a step back, we have a four pillar view: supply and demand, affordability and credit availability. Those first two, we kind of think they're the larger structural kind of underlying tides of the housing market. It's difficult to change them so much on a month-to-month or a year-to-year basis. Affordability and availability are those dials that determine kind of the shorter-term changes to prices to activity. And I think just to highlight one of them, housing affordability, it's deteriorating. Not only is affordability itself at a level we haven't seen in at least the past 35 to 40 years when we're comfortable with the data, but the pace with which it's deteriorating, if we look at it over the past three months, over the past six months, over the past 12 months, we've never seen affordability deteriorate this quickly in the housing market.
Joe: (05:10)
So how is it that housing prices aren't gonna crash? Because if the price of a new 30-year mortgage in many cases, I mean I want to look it up because I wrote about it last week, but I think like, I don't know, [it’s seen a] huge jump... Let's start with that question. A) What is the jump or the decline in affordability? How would you convey it, what we've seen and how is the market not gonna crash with such an affordability shock?
Jim: (05:40)
I think that's an incredibly important question because it is something we get asked so frequently. People’s memories go back to the great financial crisis. And they're seeing not similar trends in affordability deterioration, but that's the last time things were this significant, right? And so I think first of all, you asked the extent of the affordability deterioration Home prices, each of the past 16 months would've been a record in year-over-year growth. If we were comparing it to 2004 and 2005, we have significantly surpassed that when you add mortgage rates up over 300 basis points since the beginning of the year. Those things are gonna combine to lead to the monthly mortgage payment on the median priced home up over 50% year-over-year. If we include incomes, the kind of third variable on that affordability calculation, we're only up 46% year-over-year.
So we've deteriorated incredibly substantially. The GFC, that year-over-year deterioration never exceeded 30% -- we capped out in the twenties. But why we think home prices aren't going to crash here, why we do think this time is different, is because the question we have to ask after affordability deterioration is who's affordability just deteriorated?
The structure of the mortgage market itself is very different today than when we compare it to 2004 to 2007. If I were to just take one specific aspect of it, it's the overwhelming percentage of mortgages that are fixed rate. We think that over 90% of the outstanding mortgage market is fixed rate. We were much more heavily skewed towards adjustable rate mortgages in the early 2000s. And so as mortgage rates went higher, the monthly payment for current homeowners was resetting higher as well. This time around, especially when you consider the record amount of mortgage origination volumes in 2020, the fact that we broke that in 2021 for a new record amount of mortgage originations, most of these homeowners were able to either buy their home or refinanced their mortgage at historically low rates. Their affordability is locked-in for 30 years. They're not seeing affordability deteriorate. This deterioration is coming for first time home buyers, prospective home buyers. That's where this sits.
Tracy: (07:49)
It's always the the first time home buyers that seem to be in the worst place, it feels like. But this is actually something I wanted to ask you. So given the preponderance of fixed rates, do higher rates basically just mean that people who got a good deal are gonna be reluctant to sell, especially at a time when, you know, prices might be softening, but definitely at a time when they know that if they're going to take out another mortgage, it's going to be at a higher rate?
Jim: (08:16)
Absolutely. And it's something we refer to as the lock-in effect. They're kind of locked-in to their current homes at these lower rates. And we mentioned housing activity versus home prices earlier. We do think this is going to lead to a different evolution of those two kind of paths of the housing market. Current homeowners, in order to sell their home in a lot of instances would have to take out a mortgage that might be 200, 250, 300 basis points higher than their current mortgage. That becomes prohibitively expensive when you combine it with how much equity they have in their homes. They're just not going to be willing to sell their home at the lower price point that might be more affordable for the first time home buyer. So what we think we're already seeing, what we anticipate continuing to see going forward, is that the inventory, the listings of existing homes available for sale -- we have that data going back for single unit homes to the early 1980s. It was never lower than it was in earlier this year.
We've been increasing just a very little bit off the bottom, for the past three months. But we think that they're going to keep listings tight, which will keep home prices more supported. Like, if we think about Case Schiller, probably the most frequently quoted home price index, it uses something called a repeat sales methodology. So when a home is transacted, it looks at the last time that home was transacted. And so if we're not going to be selling those homes at lower prices than they were purchased, that's going to help support home price activity. But on the other side of this, it means that that the existing homeowner is also not buying another home after they sell theirs, which we think is going to kind of exacerbate the decrease in sales volumes. So you can see a sharp drop in sales without necessarily that corresponding drop at home prices.
Joe: (09:56)
So it's really, I mean obviously if you're look the first time home buyer, this is not a pleasant time. So it's a bad time to buy a home, it's a bad time to sell a home.
Tracy: (10:08)
It’s bad time for renters too. For homeowners, for renters, for everyone really.
Joe: (10:12)
And it seems like it's a really bad time to be a broker or realtor. It seems like that is the space that's going to sort of bear the burden of adjustment. You know, it's just interesting, getting back to the price question, the two things that it seems like going back to the housing crash that really forced sales were A) these mortgage resets. So suddenly an affordable mortgage becomes a less affordable mortgage and B) a deteriorating labor market. So if you get laid off and you don't have much equity in your home, you kind of have to sell it. Neither of those are currently in place.
Jim: (10:46)
We agree with that statement completely. We've talked about affordability. The other pillar that was kind of the short-term dial that we focus on is credit availability. I think when people hear credit availability, especially with the GFC in your mind, you go towards the borrower characteristic piece of that. You go towards FICO scores, loan to value ratios, debt to income ratios. The kind of characteristics that we like to think of when we're thinking about the probability of a mortgage defaulting, something along those lines, or the likelihood that it will prepay on the other side of that.
We don't capture the product aspect, the product risk aspect of credit availability as much. And that's what you just hit on, right? You had this proliferation, the subprime mortgage back securities market for instance, that got so large in 2004 to 2007. First of all, that market doesn't exist anymore. But a big characteristic of that market were things we called 2/28s or 3/27s, short reset ARMs that were fixed at lower rates for two or three years before adjusting for the final 27 or 28 years of that mortgage’s life.
Those products made up a significant chunk of the mortgage market back then. They almost effectively do not exist today. And when you think about what that inherently asks a homeowner to do, a mortgage borrower to do, is in month 25 or 37, when that payment's about to change to a place that could be unaffordable, especially as the unemployment rate is creeping up and they might not have that income anymore, they need to be able to refinance that mortgage if credit standards are tightening. At the same time, if home prices have flattened out, if they've started to come down a little bit and all of a sudden there isn't excess equity in the house, all of a sudden that refinance is not going to be feasible for that borrower.
And they're effectively in a place where it's going to be very difficult for them to make that monthly payment because those products don't exist anymore. You just do not have those resets. You don't have a homeowner that's reliant upon the credit availability environment going forward and credit availability -- it tightened. We gave up six years’ worth of easing in the six months after the onset of Covid in March, 2020. We’re at the tightest levels we've been in in effectively 20 years. And if anything, because of risk-weighted asset stresses at large banks, we think the path from here might even be towards tighter lending standards. And so, the quality of mortgage credit is incredibly healthy. We don't think that because of the lack of reliance of homeowners on the ability to refinance, we don't think that's going to force them into defaults and foreclosures. But that also means that we think that the risk of a dramatic increase to default and foreclosures that could, if we think about what could bring home prices down, it's those distressed transactions, those forced sellers
Joe: (13:22)
Like I said, divorce.
Tracy: (13:24)
Divorce is very distressing. I want to get into distressed sellers, but just before we do, the other thing I think about, when I think about pre-2008 housing and the subprime crisis, is I think about inventory and the housing market was so hot -- credit, as you just described, was so ample everyone could get a loan. There are all those scenes from that Big Short movie about going down to Florida and everyone has like five properties. But the other thing I think about is just lots of homes getting built in that environment. How are you viewing the inventory question at the moment and how does that feed into your housing forecast?
Jim: (14:04)
We think it's one of, if not the most important statistic right now. When we think about inventories, we view it from three angles. You mentioned home building, there's the new inventory, there's the listings. We talked about the lock-in effect, existing inventories, and then there's what we call shadow inventory or distressed. Those are those defaults and foreclosures. That's what you would need to really provide kind of downward momentum for big year-over-year decreases in home prices.
As I mentioned, because of credit availability, we don't think that that last piece is going to play a material role in this cycle. So you think about the other two. Existing inventories, we already mentioned the lock-in effect. One statistic that we've discussing a lot recently is months of supply. Now months of supply has been -- despite how low inventories are -- the fastest increasing piece of the inventory metric universe, if you will. And the reason for that is because it's an equation. The numerator (inventories) started to increase a little bit from their all time lows. The denominator (sales), sales volumes have already pulled back materially.
Tracy: (15:08)
Right. So months of supply is the number of months that it would take for the existing inventory to get sold at the current sales pace.
Jim: (15:18)
Exactly. And if we think about the absolute level of months of supply right now, we're sitting right around four. And that's total months of supply for units for sale, for both existing and new versus total new and existing home sales. And that number, the general rule of thumb is if you are below six months’ of supply, then that's a tight inventory market. That is theoretically going to be a seller's market because there's more demand than there is supply of those homes. And that historically has seemed to hold true. If we look at total months of supply going back to the 1980s to today, whenever months of supply has been below six -- and again we're at four right now -- home prices have continued to be climbing six months forward. And that has been the case 100% of the time.
Joe: (16:04)
How low could it go? So I'm just looking at the last, you know, this is what's so fun about housing is there's just a million ways to slice and dice this. But I'm just looking at the last existing home sales for August: seasonally adjusted annualized rate 4.8 million. But that's a still a bit higher than, you know, that's higher than it was in 2010. Could it continue to go substantially lower from here? If there's that divergence that you're talking about where activity and prices diverge, how extreme could that get?
Jim: (16:32)
Yes. So we do think that it will continue to go lower from here with current homeowners locked-in with affordability pressures from new home buyers. In fact, if we look at the affordability deterioration, we compare that to the great financial crisis, it's been worse. It's been faster. But if we kind of index both periods to when the affordability deterioration really started, we're outpacing the great financial crisis to the downside in terms of how fast sales have fallen. We think that the conditions that we've talked about could allow that to remain the case for at least the next six to 12 months. Our existing home sales forecast in our base case have us falling basically to below 2014 levels. So we don't think that the peak to trough will be as substantial as it was during the great financial crisis. So we're not entertaining those kind of 2010 levels. But you mentioned we're at 2017, 2018 right now, we could see it coming down to about 2014 levels in the base case.
Tracy: (17:40)
What kind of supply response would you expect from the home builders in this kind of environment? So, you know, people have been talking about the US being structurally short on housing for many years now. But at the same time, interest rates are going up. There's this big question mark over the future of the market as we've been discussing. Would you expect them to ramp up production in that environment? It seems unlikely.
Jim: (18:04)
We agree with the final piece of that statement. We do think that it is unlikely right now. We agree structurally short supply right now -- we have estimates on that. If we wanted to be conservative, 2 million units underbuilt, if we wanted to be a little bit more aggressive in our assumptions, we can get that number to 6 million units underbuilt. You would think that that would call for a higher rate of home building. And by the way, those estimates are for both single unit and multi-unit, housing holistically. But we're seeing some interesting dynamics there. Builders have been responding to what had been record growth and home prices. This tight inventory environment building, single unit building in particular, increased pretty spectacularly in the immediate aftermath of Covid. In fact, we hit all-time lows. The data there goes back to 1965 that we use, in kind of the winter of 2012. So this was kind of a final pop after almost a decade of growth in building volumes.
But now we've plateaued. And you mentioned a little bit earlier, Tracy, the difference in building volumes today versus the great financial crisis. Let's level set with what that decade of growth in building has, where that's brought us. If I look at 12 month trailing single unit starts, we're only back to 1997 levels. So we haven't crossed 2000. We haven't gotten to 2002 or the the real building pop in ’04, ’05, ‘06. But because of things like supply chain issues, we talked about labor market issues very briefly earlier. The units under construction, we pay so much attention to starts, we pay so much attention to completions. The time in between those, when the shovel's broken ground but you haven't finished the home yet, because of these backlogs, single unit starts back to ‘97 levels, units under construction are back to 2004 levels. So you do have a little bit of a backlog that needs to be cleared.
We do think that this is going to, when you combine it with affordability pressures, which is exaggerated by the mortgage rate moves, we think this is gonna lead builders to pull back. We think single unit starts are going to come down pretty sharply in the fourth quarter. We think they're gonna be down in 2023 compared to 2022. So we don't think that it's as strong an environment for that behavior.
Joe: (20:10)
Yeah. I'm looking at the, well, I'm actually, I pulled up a chart of multi-family units currently under construction. It's one of the few lines in housing that is still like a straight up, right, because I guess it is just so slow with the process of building all these things that they're still getting done. I guess, if you start a new construction, you finish it.
Jim: (20:31)
We'd like to believe that once you break ground, that you're going to make your way towards finishing, at least some point in the future. And you're right, the multi-unit under construction, one of the charts we see pretty frequently, is total units under construction has finally passed the great financial crisis. And we do think that you have to take a step back and look at this single unit versus multi-unit narrative. Single unit, as I mentioned, is back to ’04. Multi-unit, I believe the number is back to where it was in the 1970s. It's very high.
Tracy: (21:05)
You know, I was in Dallas recently and the number of multi-family homes that have been built there is just crazy compared to what it used to be. It used to all be single family. But anyway, since we're talking about supply, one thing that has come up on the show at various times is the idea of a certain cohort of homeowners, the baby boomers, many of whom bought their houses at relatively low prices and have seen them appreciate. The idea that, you know, eventually, let me think how to phrase this, eventually they're going to pass on, maybe, you know, they'll retire or have to go to nursing homes or something will force that inventory to get unlocked. Is that something that you're keeping an eye on?
Jim: (21:48)
Yes. From a demographic perspective on the housing market, we spend a lot of time talking about Millennials and Gen Z and the demand that they're going to represent as they roll through. We do think that you need to start focusing on the baby boomers. When we look at the percentage of homes, of owned homes that are held by people over the age of 65, from 1980 to 2012, it is a very consistent number. It's roughly 25% of the housing stock. It oscillates between 24% and 26%. From 2012 to today, it's gone from 25% to roughly 33%. One out of every three homes in this country is held by somebody over the age of 65. When we look at how long they've owned those homes, over 50% of them, roughly 54%, moved in before the year 2000.
So when we think about our activity forecasts, we think sales are going to fall for the dynamics we've discussed. We think prices are going to be more protected. That doesn't mean that they won't turn a little bit negative year-over-year, but when we think about what are the stresses to that scenario, it's where could an uneconomic seller, if you will, where could an uneconomic seller evolve from? And we do highlight this group as one of those potential uneconomic sellers. They have a lot of equity in their home. If they own a home today, odds are, I mean we know that over half of them moved in before 2000.
They owned that home in 2008, they saw the property, the value of their property fall. They saw it stay below its original value for almost a decade. Perhaps as headlines come through, they're going to be more willing to sell that property at a lower price point than we expect given the lock-in effect that we've talked about. Now, the counter argument there is aging in place. That trend has happened a lot more frequently. People are living longer, they're living in their homes longer. We don't expect this supply to be a factor in our price forecasts for at least another decade. But if that were to come up sooner, that's where we kind of get into more of a bear case and that would provide more pressure on home prices than we're currently expecting.
Joe: (23:49)
Before I forget, just on the home prices question itself, some of these indices have shown some declines, right?
Jim: (23:56)
Yes. And when we think about home prices, there are a lot of different indices, a lot of different ways to interpret the indices. We actually just revised our home price forecast down the last week. And one of the things that precipitated that, we talk about year-over-year home prices. Month-over-month home prices for Case Shiller, turned negative in July. First time that's happened, on a seasonally adjusted basis, I believe, since 2012. First, so that happened in a decade. Now we already thought the pace of growth was gonna slow. We just expected that to happen in September. It's happening a little early and it's happening in certain parts of the country more so than others. California we're seeing price declines on a month-over-month basis. Denver, Seattle, Portland. Those are some of the bigger, especially Case Shiller NSAs that are already showing that month-over-month price decrease. And in some instances you're seeing three or four percentage points down. Year-over-year, even in those metros, we're still up 9%, 15%. There are some places that have seen it up much more spectacularly. But that second derivative, if you will, is changing and the pace of that decrease is accelerating. And that should continue to happen as we go into the back half of this year, the first half of next year.
Joe: (25:05)
So why shouldn't someone look at that and say, ‘Oh, it's happening, the price decline. Like why is that not a signal of actual like sustained declines?’
Jim: (25:15)
So the reason that we don't think it's a signal for actual sustained declines is because A) for true home price declines to be dramatically in excess of what we're forecasting, so that’s like year-over-year, 8%, 10%+ percent, we think you would need distress, you would need forced sellers that really need to hit a lower bid on their home. You've mentioned kind of the things that we typically look at from a turnover perspective, right? Death and divorce, other metrics that would make you forced to sell a home, that can be roughly 5% of the housing market. That's not enough of a metric for us to really weigh on home prices. But the other piece is supply, listings of homes is so tight if people aren't willing to sell into the kind of depressed demand that we're talking about, what we think you're going to see is a market that kind of stalls out here. And that will lead national home prices to show a little bit of weakness. Our forecast of down 3% year-over-year, December, 2023, like the negative headline attached to that is that's down 7% from today. Okay. The positive headline attached to that is that only brings home prices back to January, 2022. And that brings you back to January, 2022, which is 30% above March of 2020.
Tracy: (26:26)
So you changed your forecast relatively recently mm-hmm. I think you were looking for, I mean basically flat or something like that. And you changed it to -3%, as you just mentioned. What was the sort of tipping point that you saw in the market, that made you hit the button on that?
Jim: (26:41)
Yes. So I think the fact that we saw home prices turn negative a little bit earlier than we thought they would. Sales volumes were coming in a little bit weaker than our forecasts had expected. But forward-looking expectations changed as well. Like when we think about research at Morgan Stanley, we're taking into account what all of our various teams are saying. Our US economics team, given the persistence of inflation, they recently raised their call for monetary tightening, adding 25 basis points worth of hikes to the November, December, and January meetings. Our US interest rate strategists on the back of that raised their forecast for the 10-year. So they raised their forecast 50 basis points in December. They raised it 70 basis points to 3.75% for the middle of next year. That changes where we think mortgage rates could be throughout next year, which means that the deterioration we've seen in affordability, there won't be any real relief next year now. And so we were expecting that perhaps kind of during the spring selling season next year, that was providing a little bit more support. That support is now absent.
Tracy: (27:42)
So this actually leads really nicely into something that Joe and I wanted to ask you about, which is, when interest rates go up, how does that actually feed into mortgage rates? Because as we mentioned at the beginning, you know, we have seen this unprecedented rise in mortgage rates. I think the average 30-year is at almost 7% in the US now, 6.75%, something like that. And there's this huge spread between 10-year Treasury yields and mortgage rates. Again, something else that's at a record. What's going on here? Why does it seem like mortgage rates are increasing at an even faster pace than benchmark interest rates?
Jim: (28:20)
I think there's a couple of reasons for why that spread that you're talking about between mortgage rates and Treasury rates has increased. And one of them is if you're a mortgage-backed securities investor, you're structurally short rate volatility and not only have mortgage rates or interest rates moved higher, but volatility has been incredibly high. The day to day, week to week swings we’re seeing in the 10-year Treasury, that volatility would in and of itself kind of weigh a little bit on the spread that we're talking about. But I think the other aspect to this is who are your buyers of mortgage-backed securities? Who kind of supports that mortgage rate? For the past couple years, the Fed has been an incredibly large buyer, quantitative easing. They were directly buying mortgages. They're no longer buying mortgages. Banks, because of risk-weighted asset pressures, they're no longer going to be buying conventional kind of Fannie and Freddie mortgages going forward. What we're seeing from a dollar perspective, a cross currency perspective, might make it a little bit more difficult for overseas investors to be buying mortgages. And so when you have so many of what have been your larger buyers over the past couple years for various reasons, not as willing and able to step into the market right now, combined with the rate volatility we've seen, or perhaps even exaggerated by the rate volatility we've seen, that can kind of lead to that gap in spreads.
Tracy: (29:42)
There's a certain irony that post-GFC capital requirements are now leading to higher mortgage rates and potentially causing an affordability issue, isn't there?
Joe: (29:53)
You know, this is the part of the interview where I say ‘could you clarify for our audience,’ but what I actually mean is, could you clarify for me? Can you walk through why a MBS investor is structurally short rate volatility, specifically? How does that work?
Jim: (30:10)
It's basically because of, for better or worse, the freely prepayable nature of the mortgage market in the United States, right? As rates rally, as interest rates come down, as mortgage rates follow them down, your homeowner is going to be much more likely to prepay that mortgage returning principle to the investor in a lower rate environment where their ability to invest it is challenged., right? As mortgage rates go higher, all of a sudden that mortgage-backed security that you bought, which you had an expected duration on, it's going to be longer as people are more incentivized or locked-in to stay in their home right now. And that's kind of the tip of the iceberg for that aspect.
Joe: (30:48)
Okay. I have another mortgage rate financing question and the Mortgage Brokers Association, you know, their mortgage applications data came out and I saw that refi activity is down 90%. And my question is, why is it not down 100%? How is there anyone still refining a mortgage today? Who is who like I've refined a mortgage, but that was a few years ago, like who's refi-ing today?
Jim: (31:13)
That is a fantastic question and we think that, harkening back to kind of the beginning of our conversation, it feeds into how much of the housing market and the mortgage market are at levels that we haven't seen before. So borrowers are out of the the money to refinance. So you're thinking that should be zero, right? They're more out of the money than they've probably ever been on a weighted average basis. But on the other side, homeowners have more equity in their homes than they've ever had before. And so if we're talking about a borrower who, if you bought a home with a 20% down and home prices are up almost 40% over the past two and a half years, you can take a little bit of that equity out of your home.
Joe: (31:55)
So that goes into the refi index, taking that?
Jim: (31:58)
Yes. So refi is a combination of both rate and term. So people who just refinance to get a lower mortgage rate, but also the cash out equity.
Tracy: (32:22)
So you mentioned MBS investors being structurally short volatility, which makes me want to ask about where are the GSEs nowadays? They used to be a big market stabilizer, a stabilizing force, in the market and it seems like they're sort of not there anymore, to put it mildly.
Jim: (32:45)
I think that they're, like when we walk through the buyer bases earlier, they weren't one of the buyers that I mentioned, right? And so that puts more of an onus on those other buyer bases and some of them are stepping back for those reasons we alluded to.
Joe: (32:59)
Can we talk a little bit more about, speaking of a buyer stepping back, how do you quantify the significance? You know, so rate volatility is one contributor to the widening spread between mortgages and Treasuries. And then the other one is, you know, the Fed was hoovering up a lot of MBS for a long time and now it's not and it's going into quantitative tightening mode. How do you quantify that or think about the effect of the Fed's role in mortgage rates?
Jim: (33:28)
So Jay Bacow, who is our co-head of securitized products research, he runs our agency MBS research team. One of the things that he's done a great job of with respect to when the Fed's been involved, when the Fed hasn't been involved, is kind of looking at, we talk about this mortgage spread, kind of looking at how the mortgage basis has moved or what level it's existed at depending on the behavior of the Fed over time. Because when the Fed is buying, when you have this large buyer stepping into the market, that spread should be tighter. You have a lot of this demand there. When they're not buying that spread should be wider, right? And so that's definitely something that we keep in mind in terms of thinking about what that mortgage spread has looked like over time and accounting for what the Fed is doing at different points in time.
Tracy: (34:16)
So I have a slightly weird question just going back to supply, but I bought a very old house this year which just had one of those like energy efficiency things done on it and we got like the lowest score possible because there's absolutely no insulation. How much do technological advances in housing potentially drive supply? I'm thinking, you know, if everyone decides, ‘oh energy prices are so high, I want a really energy efficient house with solar panels on it’ and that sort of thing, could that drive like a new round of activity?
Jim: (34:52)
Congratulations on the home purchase.
Tracy: (34:53)
Oh, thank you. As I watch heating oil prices go up I’m starting to doubt myself, but thanks.
Jim: (34:59)
But I would view it less as a desire to trade up for a more energy efficient home, if you will, especially given what's happened to home prices and mortgage rates right now. And perhaps more of a willingness of that homeowner to maybe remove some of the equity like we talked about, from that home. There's a lot of that equity there, and perhaps spend that on their current house to kind of improve the efficiency.
Joe: (35:25)
You sort of anticipated my question. Could the lock-in environment where it’s like, and you see people talk about this all the time, it's like, ‘I can't move anywhere because I don't want to give up my mortgage and the market's terrible. Could that sustain renovation activity? Because I think renovation activity also really kicked into a high gear during the pandemic and everyone was stuck at home. It’s like, I gotta fix my whatever. But could that lock-in have that same effect?
Jim: (35:53)
That is certainly an option that that could happen right now. You think about how we typically talk about, ‘oh, this is a entry level home’ and then you have your move up home buyer and if we've made it much more difficult to kind of progress along that path, then you're kind of looking at your current house and saying, ‘well, what do I need to do to this house to make it more accommodative of how my lifestyles going to evolve? How my family might be evolving? How my trends and work from home might be evolving?’
Joe: (36:23)
Well, you know, so staying on this supply and demand question, can you talk a little bit about, and we were talking about the boomers earlier, but you say, you know, there's a lot of interest in Millennial home buyers or maybe Gen Z home buyers. What is household formation? What is the process that drives household formation? And my understanding is, I think it's spiked quite a bit, but I don't, you know, I don't have a sense of what it actually is or why it would spike due to Covid. But what is household formation? What drives it and how is the change in that going to affect the market going forward?
Jim: (36:57)
Absolutely. So when I mentioned the four pillars at the top, one of them was demand. And when I say demand in this context, I mean household formations. That is the metric we're looking at. So to talk about household formations, let's talk about how we define a household, if you will. Right? And so basically a household is a unit living together in a shelter. It can be ownership or rentorship. I like to use an example where you basically have four people that just kind of, maybe they graduated from college. They moved to, let's say New York City, where we're sitting right now. And they live in one apartment. They are one household. When they moved, when they graduated, when they moved to the city, that was a formation of a household because as part of their parents' household before, that they didn't count as one. So you have one household formation.
What we're really going to be talking about is headship rates. That's the percentage of any group, cohort of the population, how you choose to define it. We're defining it by age here that heads their own household. So this group of people, okay, their headship rate’s 25%, four of them in one household, two years later, they all move into their own apartment. We now have four households. Formation would be three. We went from one to four. It's a net figure. And the headship rate for this very small cohort is a hundred percent. So when we think about how household formations are going to evolve, we're looking at how those headship rates evolve in particular by age. The steepest part of that slope is as people move through their twenties and early thirties, kind of branching out on their own, starting with a heavier roommate environment towards a lesser roommate environment in general. And that's why there's so much focus on Millennials and Gen Zs in 2019. You mentioned how much we've seen recently the headship rate, the percentage of people in there at 25 to 29, 30 to 34, their headship rate was close to 50-year lows.
Joe: (38:44)
Huh.
Jim: (38:45)
And that's for a number of reasons. We hear a lot of discussion about things like student loan debt, the fact that a lot of this generation graduated into a recession making it a little bit more difficult to kind of form your own household. Those kinds of -- taking on excess roommates, moving into your parents' basements, that brought them down to 50-year lows. But household formations were still coming in above long-run average because you had such a large group of people moving through the age cohorts that were so important for household formations. So the rate at which they were forming were lower, but the number of people so large.
Joe: (39:17)
This is so helpful. This is like answering questions I've been too embarrassed to ask for years. This is exactly why. So then what happened in 2020 that caused the spike?
Jim: (39:25)
So I think that you had a couple dynamics that were playing out in 2020, 2021 that helped cause the spike. I think A) you had the pandemic, which two reasons you had a kind of risk aversion -- people not wanting to live in such densely populated areas where in a lot of instances, they’re likely to have roommates, they want to live in less densely populated areas, more likely to have single family housing. We track home prices by zip code population density. The gap between suburbs and less densely populated urban areas versus densely populated urban areas gapped out over the course of 2020 and 2021 to the largest we've ever seen. And again, that data goes back [to the] late 1980s, early 1990s. But so, risk aversion. Work from home allowed them to make that move.
And then we've talked a lot about mortgage rates. As mortgage rates were falling to all-time lows, the buying power of this cohort is now much more substantial. And so that kind of just exaggerates their ability to kind of, to drive home prices up there and to afford buying homes. Before we had this record growth and home prices at the same time, leaving these densely populated areas, rents coming down, that also enabled people who weren't necessarily making that move out, to kind of decrease their roommate count. And so you had household formations from that perspective in terms of going from two or three roommates to living by yourself and then formations from going from a renter in a roommate situation in a densely populated area to kind of the less densely populated area. So that took us from above long-run average to well above long-run average.
Joe: (40:54)
Tracy, I had totally forgotten that was such a big story. The suburbs versus the cities, that was like such a big thing in 2020.
Tracy: (41:00)
Yeah. I think a number of people have moved back into the city now. Not me though. I'm in the country, sort of. Anyway, you mentioned Millennials there and we've been talking a lot about housing affordability and there has been this discussion about whether or not, you know, people that have massive student debt might have difficulty saving in the current environment, whether or not they'll be able to afford houses in the future. There's also a thing that crops up every once in a while where people talk about, well maybe a lot of younger people don't want to own homes simply because they might be into, you know, apartments that come with lots of amenities like pools and movie rooms and things like that. What's your impression of, I guess, the American dream or the viability of the American dream at the moment? Do people still want to own houses, as you know, affordability really comes into question?
Jim: (41:52)
Anytime we've seen kind of like the softer almost survey-based data, it still points towards people wanting to own homes. I do think that affordability pressures, that credit availability, like yes, we think it's probably moving tighter in the short-term. But even if it starts to move wider, some of the regulations have been put into place post the GFC, make it unlikely that we're going to see lending standards eased to anywhere close to what we saw in 2004, 2007. I say that to imply that right now the home ownership rate is between 65% and 66%. We don't see it going back to 69% to 70% like we saw back in the early 2000s. We do think that there's still a desire to own homes, the step towards owning homes occurring a little bit later in people's lives. But we also think that single family rentership, which I think has become a much more talked about topic over the course of the past 10 to 15 years, largely due to the institutional ownership of those homes, we think that that's going to become, or we think it always has been and will continue to be kind of another pillar of housing, of shelter in this country.
Tracy: (43:04)
So, uh, we talked a little bit about your forecast her next year, which is the minus 3% decline in home prices. What's the variable that you are most closely watching that could change that outlook
Jim: (43:18)
Supply. We are watching inventories. If uneconomic sellers come from areas that we're not expecting, if supply increases faster than we think it will, then all of a sudden the likelihood that you have people willing to sell into what we already think will be a meager demand environment increases. And that likelihood would then bring home prices lower. So that's the number one variable we're looking at.
Tracy: (43:44)
All right. Well, Jim Egan, it was lovely having you on Odd Lots. Thank you so much for taking the time to walk us through household formations and how mortgage rates are actually set.
Joe: (43:53)
I like asked about five questions that I was too embarrassed to ask for, you know, over the last 10 years. So I appreciate you coming out and answering them, clarifying. I actually feel like I understand a few.
Jim: (44:05)
Thank you for having me. It a lot of fun.
Tracy: (44:23)
Well Joe, I thought that was fascinating. Just to sort of really lay out how unusual this current moment is and how we're sort of like breaking records on a lot of housing market indicators or, you know, like structural rates and things like that. The other thing that stood out to me was just that lock-in idea.
Joe: (44:41)
Yes. Well, you know, it's funny, University of Michigan, I think in their economic sentiment they ask these questions like, ‘is it a good time to buy?’ And people these days, they say no. And then the other question they say, ‘Is this a good time to sell? And that was really high up until recently because it's like a seller's market, but that's plunged. So we have a very weird situation in which it's neither a seller's market nor a buyer's market, which means we're just going to get this like freeze where there's just not much transaction. And look, I don't know what's gonna happen with prices, but I find this idea compelling that if supply doesn't shoot up, it's hard to get a big drop in prices.
Tracy: (45:22)
Yeah. I think that kind of goes to Jim's final point as well about it's sort of all about supply and inventory at the moment. The other thing that I found interesting, and this has come up in a number of conversations at this point, is the idea of the marginal buyer of a lot of bonds -- so in this case, mortgage bonds -- just not being there anymore. And it's sort of a similar story for, for Treasuries too. But when it comes to MBS, that's feeding into the rates. And so you can sort of almost draw a direct line between higher capital requirements and standards to the massive shooting up of mortgage rates that we've seen.
Joe: (45:58)
Well, and to the extent that MBS are a sort of bet on low volatility, you know, the Fed doesn't care about, you know, the Fed is not a profit-seeking entity. I guess it technically, I don't know, maybe for political reasons, wants to have some money to remit to the Treasury, but that's not why the Fed exists. And so it could absorb that volatility. Whereas when it's in quantitative private tightening mode, that volatility has to be priced. And so you see that spread and it's really wild because, so you just look at the spread of 30-year mortgages versus Treasuries and it's quickly spiked up to where we saw like March, 2020 when the entire financial system briefly went nuts.
Tracy: (46:39)
We're gonna have to put together some of these charts.
Joe: (46:41)
Yeah. Let's make a chart list. A charticle to go along with this episode.
Tracy: (46:46)
Shall we leave it there for now?
Joe: (46:48)
Let's leave it there.
You can see a bunch of the charts mentioned in this conversation over here.