Welcome to Thoughts on the Market. I am Vishy Tirupattur, Global Director of Fixed Income Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about concerns over a U.S. housing bubble amid surging home prices. It's Tuesday, May 4th, at 10:00 a.m. in New York.
If you're in the market for a home, or someone who takes a passing glance at real estate listings or apps, I don't need to tell you that U.S. housing is on a hot streak.
Home prices, as measured by the S&P Case-Shiller Index, rose 12.2% over the past year, with prices surging across all 20 of the metropolitan areas tracked by the Index. That amounts to an increase of $35,000 in the median selling price for homes from just a year ago and marks the fastest pace of increase since 2006.
Unsurprisingly, it calls to mind the boom in home prices during that period, along with some unhappy memories of the bust that followed, which culminated in the Global Financial Crisis in 2008. However, unlike 15 years ago, the euphoria in today's home prices comes down to the simple logic of supply and demand. And we at Morgan Stanley conclude that this time the sector is on a sustainably, sturdy foundation.
Of course, we are not suggesting that home price appreciation will maintain its current torrid pace. But we have a strong conviction that what we are experiencing is not a bubble in U.S. housing.
It's worth taking a look back at the run-up to the housing bubble in 2006 and why, this time, it is different. Back then, layers upon layers of leverage in the housing sector was the primary cause of the spectacularly painful bust. But contrary to the narrative that loose lending to people with lower credit scores - "the sub-prime borrowers" - was central to the excesses, we think it was more about the type of credit they had access to. Mortgage credit risk consists of both borrower risk and mortgage product risk. Borrower risk captures the metrics we typically use to assess the likelihood of a default on a mortgage, such as credit scores, loan-to-value ratios, and debt-to-income ratios. Product risk lies in giving a borrower a type of mortgage that has a higher risk of default, even after controlling for those borrower characteristics.
These products were inherently risky because they required home prices to keep rising and lending standards to remain accommodative so that homeowners could refinance before their monthly payment became unaffordable. However, when home prices stopped climbing, these mortgages reset to payments that borrowers could not make, leading to delinquency and foreclosure. As foreclosures and subsequent distressed sales piled up, home prices fell further, creating a vicious cycle.
Such risky products made up almost 40% of all First Lien mortgages from 2004 to 2006. Today, their share is down to 2%. Not only are lending standards much tighter this time around, but the leverage in the system has also been reduced dramatically. Prior to the financial crisis, the total value of the U.S. housing market peaked at $25.6T in 2006, with total mortgage debt outstanding of $10.5T for an estimated loan-to-value of 41.2% for the entire housing market.
Today, the value of the US housing market has jumped to $33.3T, while the total mortgage debt has only increased to $11.5T with an estimated aggregate loan-to-value of just 34.5%. These changes give us the confidence that the current system of housing finance is healthy and on a sustainable footing.
As I mentioned earlier, this time, supply and demand factors are the tailwind for home prices. Millennials continue to drive household formation at a rate that is 30-50% above the historical rate of new household formation. This means demand for shelter is likely to remain robust. My colleague James Egan points out in his latest Housing Tracker that affordability actually remains good despite sustained increases in home prices and mortgage rates inching higher. And monthly mortgage payments as a percentage of income remain near the most affordable levels in the last five years. Against this backdrop, there is a nationwide shortage of supply. The number of existing homes available for sale has plummeted to historical lows, while the supply of new homes remains very muted. As a result, the overall supply of homes sits near record lows.
Bottom line? This robust demand and highly challenged supply, along with tight mortgage lending standards, may continue to bode well for home prices. Higher interest rates and post pandemic moves could likely slow the pace of appreciation, but the upward trajectory remains very much on course.
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