By Jay Bacow, Co-Head of U.S. Securitized Products Research at Morgan Stanley
Records are made to be broken. The housing market embodies that aphorism. Last month, the Case-Shiller index set a record of 20% growth in home prices. This past Tuesday, it posted 20.6%. Combined with mortgage rates that are 200bp higher on the year, this price growth means affordability has deteriorated more in the past 12 months than in any year on record (see "Housing Affordability Is About To Crash The Most On Record"). Part of the reason lies in the record-low number of homes for sale. Not since 1982 have consumers reported worse sentiment about buying a home. Okay, this last one isn’t a record, but you get the point. While consumers may not think this is a good time to buy a house, the record-breaking housing market raises the question of how to invest in it.
Given the run up in housing in the 2000s – and the resulting catastrophe – investors would be permitted some anxiety. For anyone suffering from “ebulliophobia,” there are some key differences between now and then. Primarily, the pre-GFC run up in home prices was fueled by lax lending standards that elevated demand to unsustainable levels and ultimately led to a tidal wave of defaults when borrowers with risky mortgage products were not able to be refinanced. This time around, lending standards have remained at the tight end of historical ranges while supply has languished at all-time lows.
Another key difference from the 2000s is that the hit from affordability is not spread as widely. In the early 2000s, a large share of mortgage debt carried an adjustable rate, and rising mortgage rates pressured both prospective buyers and current homeowners. By contrast, the vast majority of mortgages today are fixed rate with affordable monthly payments based off mortgage rates that average 175bp below the prevailing rate. Current homeowners face little new pressure because they are “locked in” at lower rates, but that fact also makes them much less likely to list their homes. In this environment, dwindling inventories mean weaker sales numbers and more support for home prices. Against this backdrop, where do we go from here?
Housing prices and housing activities will go their separate ways. Put bluntly, housing activity should fall, but home prices will still grow. Home sales data have already weakened across purchase applications, existing homes sales, and new home sales. Despite the fall in sales volumes, the lack of inventory combined with robust lending standards should keep defaults and foreclosures low and home prices protected. Home price appreciation should slow but still finish 2022 at 10%Y and grow a further 3% by December 2023. This combination of tight supply, muted default risk, and supported home prices is a huge difference from the 2000s, so we think assets referencing single-family MBS are attractive investment opportunities.
If buying a home is the single largest investment for individuals, scaling them up to the US$8.5 trillion agency mortgage market where the government has underwritten any borrower credit risk gives investors the single largest liquid investment vehicle outside Treasuries. Agency paper provides an easy way to get exposure to the robust housing outlook.
We think market participants have more than fully priced in the removal of accommodative monetary policy from the Federal Reserve but have not fully realized how much the aforementioned dynamics will slow the new supply of paper.
Agency mortgages getting produced today have more than 100bp of spread versus Treasuries; they haven't stayed this wide for this long since January 2009. Just as we don't think the housing market is facing another crisis, we don't think the mortgage market should be priced at crisis levels. We recommend an overweight to agency MBS as one of our core fixed income ideas for the next 12 months.