Morgan Stanley
  • Thoughts on the Market Podcast
  • Mar 4, 2021

U.S. Home Prices: Is This Time Different?

Jay Bacow and Jim Egan


Jim Egan: Welcome to Thoughts on the Market. I'm James Egan, Co-Head of U.S. Securitized Products Research for Morgan Stanley.

Jay Bacow: And I'm Jay Bacow, the other Co-Head of U.S. Securitized Products Research here at Morgan Stanley.

Egan: And on this edition of the podcast, we'll be talking about the path ahead for U.S. home prices, considering both how quickly they've been climbing and also the rising rate environment. It's Thursday, March 4th, at 11 a.m. in New York.

Bacow: So, Jim, when we look at recent home price data, we haven't seen an increase this fast since prior to the great financial crisis. Are we headed towards another housing led financial crisis here?

Egan: No. I wanted to answer that question first before going into some of the details. But, look, in some ways, the growth we've seen in home prices is even more impressive today than it was in the early 2000s. Now, there are a lot of reasons for us to believe that the housing market is in a very different place today. But two of the reasons we want to hit specifically are credit availability and the supply of housing.

Now, I'll talk about credit availability a little bit here. When we think about what led to the housing crisis in 2006, 2007, 2008, the first thing that's going to come to a lot of people's minds is the fact that we extended mortgage credit, we gave mortgages to borrowers with lower credit scores. After all, this was deemed a subprime mortgage crisis, and that was true. We're not going to fight the headline of that narrative. But if I look at the median FICO score or the 10th percentile FICO score from the mid 90s to 2006, it didn't change all that much. What really changed was the type of mortgage product that we were giving to those borrowers.

What all these mortgages have in common or what a lot of these mortgage products have in common is that they give the borrower smaller payments up front that then reset to what can sometimes be much higher payments after a shorter period of time. And what these products are implicitly asking the borrower to do is refinance their mortgage at that point in time when those payments increase. Right? And if home prices continue to move higher, then not only can the borrower refinance, but the borrower might be able to take out equity out of their home. They might be able to do a cash out refinance and be in an even better place from a financial perspective.

However, the flip side of that coin is, let's say home prices don't keep going up. Let's say that credit standards or the willingness of a lender to extend mortgage to that borrower is, or to borrowers in general becomes curtailed because of the broader macroeconomic environment. In those instances, these borrowers are now left with much higher payments, the affordability of which is far more uncertain into a more questionable economic environment. And what you get is an increase in delinquencies. You get an increase in foreclosures. Those lead to distressed transactions, foreclosure auctions, REO liquidations. And all of that is kind of a vicious cycle that works to pull down home prices.

When we think about the extent to which those affordability products had really permeated the housing market in the early 2000s, from 2004 to 2006, almost 40% of all first lien mortgages were affordability products. Today, that number is just 2% of all first lien mortgages. So the underlying risk that easier credit standards kind of introduced to the market was so much greater about one in every three mortgages back in the early 2000s. And today, it's only one out of every 50. So that's changed dramatically.

Jay Bacow: All right. So that's good news on the quality of mortgage credit. But what about supply and demand? You know, I'm thinking about trying to move out of the city, and it doesn't seem like there's any houses for me to buy in the suburbs right now.

James Egan: Right. Supply is another one of these big differences between where we are today and where we were before the great financial crisis. Those home prices climbing at very fast rates, incentivized people to build more housing units. And if we look at where single unit completions were in 2006, they were at an all time high. When you have delinquencies that lead to foreclosures, that lead to distressed transactions, that lead to falling home prices, now all of these homes that have been brought to market materializes excess supply and push down home prices even further.

James Egan: This time around, we just simply have not been building enough homes. There is not a lot of supply there. Certainly nothing that could be considered an excess. And then the number of homes being listed, the already built homes, the existing inventory, that's also at all time lows. We have 40 years of history there and we've never had fewer homes on the market than we do today. So it's not just credit availability, it's the fact that there simply aren't homes out there to buy. And so you don't have that excess supply issue that we had in the early 2000s as well.

Bacow: All right. So we don't have the excess supply and the quality of mortgage credit is good. Anything else that we should think about?

James Egan: The differences between now and the earlier part of this century extend beyond just credit availability and the supply of housing. If we look at the leverage in the housing market, just in terms of the total amount of mortgage debt versus the value of residential homes in the country, it's at the lowest point it's been in our 26 years of data there. So suffice it to say, taking all of that into context, we believe the housing market is on a much healthier foundation right now, despite the fact that home prices have increased as dramatically as they have.

Egan: But that being said, there are still risks to the housing market. One of the questions that we're getting in every conversation we have about housing these days has to do with interest rates. If we look at the 10 year Treasury, for instance, it's increased rapidly throughout the first two months of this year. And it got me thinking that the mortgage market itself could actually be exaggerating this increase in interest rates. Jay, can you explain to us how that works?

Jay Bacow: So if you're an investor in fixed income, normally you're going to have a certain amount of risk that you want to have at any given point. And we measure that risk via the duration of your holdings. Now, what's tricky about mortgages, is that their duration can change pretty quickly as rates move. And this is because when rates go up, the likelihood of homeowners refinancing goes down. When rates rally, the likelihood of homeowners refinancing goes up.

Jay Bacow: What this means is that as rates go up and the prices of the mortgages go down, investors that want to hold the same amount of risk constant are going to need to sell mortgages into lower prices. Alternatively, if interest rates go down and the prices are going up, investors that want to hold the same amount of risk constant are going to have to buy more mortgages into higher prices. And given the size of the agency mortgage market, we're talking about a $7T market, these changes in duration to keep their risk constant can at times exacerbate the rate move. And it turns out that the area in Treasury rates that they have the biggest need to change and hedge their mortgage risk is between about 125 and 175 on 10-year note yields, where we've been during the last few weeks.

Bacow: Now, while this may have exacerbated the move, we'll point out that it's probably not the main reason. And part of why it's not the main reason is that the universe of people that are hedging these moves is much smaller now than it used to be, because the Federal Reserve, along with a few other investors who aren't actually hedging their risk, has owned so many mortgages. So while the mortgage market has grown by about 50% since the financial crisis, almost all of that has gone to the Fed. So the impact of these mortgage hedging needs on rates, while it matters, is probably less impactful now than it used to be.

That being said, obviously higher mortgage rates are going to impact affordability in the housing market. And so, Jim, is this going to slow down home prices?

Egan: When we think about affordability. Right? There are three main inputs into that calculation. Its home prices, its mortgage rates and its incomes. Home prices have been climbing incredibly quickly. And now that mortgage rates are increasing, too, that's going to have an impact on the affordability of housing. Simply put, we don't think people will be able to buy as much ‘house’ as they have been recently, right?

So how we think this decrease in affordability kind of ripples through the system is the rate of home price growth is going to need to slow from where it is now, but we don't think it will turn negative. If we look at our base to bull case forecast by the end of this year, and a lot of housing activity has been coming in closer to our bull case, that shows growth slowing from a little over 10% now to somewhere between 3% and 6%. So we do think that home price growth will remain positive, but it will have to slow, and affordability is a big reason why.

Bacow: That's a pretty clear message. We're not going to have another housing led financial crisis. Always great speaking with you.

Egan: Great talking with you, Jay.

Bacow: And as a reminder, if you've enjoyed Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show. 

Home prices have been steadily climbing all across the U.S. How should Americans think about home prices, rising interest rates and affordability?

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