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.
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