Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-head of U.S. securitized products research for Morgan Stanley.
Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. securitized products research.
Jay Bacow: And on this edition of the podcast, we'll be talking about the outlook for U.S. housing in 2021 and how investors may want to view residential mortgage markets. It's Friday, January 22nd, at 10 a.m. in New York. How are you doing, Jim?
Jim Egan: I'm doing pretty good today. I think before we dive in, it might be worth a little bit of a description of what securitized markets are.
Jim Egan: OK, look, securitization is a process where an issuer makes a financial instrument by taking a bunch of assets and packing them into one group. You can securitize almost anything: mortgage loans, auto loans, credit card payments. But what takes up a lot of our time, are the securitizations of residential mortgage markets. So, let's talk about U.S. housing. Look, our outlook for U.S. housing is pretty strong in 2021.
Jay Bacow: When I think about what's happened over the past six months, it feels like the housing market's done really well. So what does that mean going forward? Is it just going to continue to go up or are we going to see a pullback?
Jim Egan: Look, the second half of 2020, the housing market strength could almost be described as Herculean. Did we pull forward a lot of demand from 2021 or is there enough to really keep this going? And while we think the foundation for the housing market overall is very healthy, our answer, depending on what statistic you're talking about, could be pretty different.
Jay Bacow: All right. So when you're thinking about all these different statistics, what are the things that you're looking at that drive your housing outlook?
Jim Egan: So we have a four-pillared framework for the U.S. housing market. Those four pillars are the demand for shelter, the supply of that shelter, the affordability of U.S. housing and-- this one we think gets overlooked pretty frequently-- the availability of mortgage credit. So I'll start with demand. Look, the number one underlying tide that drives demand in the housing market are household formations. Each new formation is a unit of demand for shelter. It can be ownership shelter or rentership shelter, but it is demand for that shelter and the demographic arguments that underpin our strong demand forecast, we think those really remain in place. Simply put, people are moving through the age cohorts, and that's the late 20s and really your early to mid 30s, that are typically characterized by the most rapid household formation.
Jay Bacow: Are these the people moving out of their parents basement?
Jim Egan: That's a pretty interesting way to look at it. And while we are looking at a generation that is more known for an incredible amount of student loan debt and the rate at which they moved back into their parents basements, we're not calling for those trends to really change all that much. When we look at household formations, one of the numbers that we're trying to look at or that we're trying to predict are headship rates. The headship rate is the percentage of any given age cohort that heads their own household. And look, because of those trends, we're at 50 year lows in terms of the rate at which millennials are forming households and, what we think is a positive for demand, we don't need to change from those multidecade lows. If we hold headship rates where they are now or, what we actually do in our forecasts, pull them a little lower over the course of the next 5-10 years, because of the sheer volume of people moving through these age cohorts, we're going to see household formation in excess of long run averages. On top of that, we think this demand is going to materialize in single family form. So that's demand for both ownership housing as well as single family rentership housing. And that's kind of a vestige of coronavirus. More people working from home, a higher level of risk aversion, we think, is going to continue to push people into less densely populated areas, a trend that we already saw manifesting itself through the latter half of 2020.
Jay Bacow: All right. So, you just talked about demand, what does supply look like?
Jim Egan: Supply is one of the reasons that home price growth has been so strong over the past few months. Back in February, we were already talking about a pretty constrained supply environment. In the months since we've gotten to levels we've never seen. We can now describe supply as historically tight and we have almost 40 years of data there. Now, that tightness in supply is manifesting in more than just a sharp increase in home prices. We're seeing homebuilder confidence levels at record highs. And we think that supply on the existing side is going to remain tight through 2021. So there's no reason for us to think that this confidence from a homebuilder perspective is going to dissipate anytime soon. Suffice it to say, single unit starts will grow in 2021. But the historically tight supply environment we find ourselves in now is going to be constructive for home prices throughout the entirety of 2021.
Jay Bacow: All right. You just mentioned home prices. What about affordability?
Jim Egan: So when we think about affordability, there are really three inputs. You mentioned home prices as one, mortgage rates are a second and incomes are a third. And affordability itself seems to be at pretty healthy levels right now. But home prices are continuing higher, mortgage rates are probably going to go higher in 2021, at least if our interest rate strategists forecast pans out. And so those are going to impact housing affordability. In fact, I would say the single most asked question of us in the housing market is, "how can the housing market clear these affordability hurdles?" Now, when we look at historical periods of mortgage rates increasing by 50 to 60 basis points over the course of a year, and going back to 1990, we have eight unique instances. In every single one of those instances, existing home sales climbed while mortgage rates were climbing, new home sales climbed while mortgage rates were climbing. It's in the 12 months after mortgage rates have finished increasing that we see a lot more variability in housing sales volumes and we have the opportunity, or there's the possibility, of home sales falling pretty sharply. So to the extent that people are concerned that affordability is going to drag transaction volumes and housing activity down in 2021, we think that's more of a 2022 story. It's not something we're really concerned about for the next 12 months.
Jay Bacow: All right. But that just three of the four pillars. What about the fourth pillar?
Jim Egan: Right. credit availability standards had been easing on the margins from post great financial crisis tights in 2012 or 2013 to where they were in February of 2020. They were still pretty tight on a historical basis. But over the nine months from then to our most recent data point, we've given up six years’ worth of that credit easing. Now, we think that those healthy lending standards coming into this crisis, coming into the coronavirus, those are some of the reasons why forbearance outcomes so far have been so healthy; borrowers coming back, current borrowers being able to sell their homes at a profit. That's a function of both credit standards as well as the positive home price appreciation environment that we find ourselves in. We think the health of the housing market, combined with how these mortgages have been performing, is going to give lenders a little bit more confidence, easing lending standards faster this time around, than they did after the great financial crisis. Now, we won't get back to February 2020 levels by the end of the year. And while we're starting from a very tight base, that will overall be a positive for the housing market in the year ahead.
Jay Bacow: All right. So that's a pretty good picture for the housing market. Now, what if you want to be actionable and put a trade on this?
Jim Egan: It's worthwhile mentioning what our forecasts are as we remain pretty positive here. We think existing home sales are going to increase by five percent year over year in 2021. We think new home sales are going to increase by 15 percent year over year. And that tight supply environment and that homebuilder confidence I talked about, we think that's going to drive single unit starts up nine percent next year. And we finish the year at about three percent year over year growth from where we are now.
Jim Egan: Now, how do we play that? There are a lot of different markets under the resi credit umbrella. Credit risk transfer has been one of the more liquid markets there, at least the most frequently traded on the secondary market. The non-qualified mortgage market has been the fastest growing market. And while there are unique differences to each of these markets, we think that the healthy foundation of the housing market, will lead to a lower level of defaults-- a lot of that comes from the robust credit standards we talked about-- as well as low losses on any mortgage that actually does default because of what we're seeing in the home price growth arena. Both of those give us comfort going further down the credit structure or going further down the capital structure in resi-credit. So we're recommending mezzanine tranches that don't have as much credit enhancement, that have a little bit more exposure to losses, because we really don't think those losses will be rolling through.
Jim Egan: But let's take a step away from resi credit. It's a big market, but it by no means is as large or as liquid as the agency mortgage market. Tell us a little bit about the agency mortgage market and what do you think in there?
Jay Bacow: The agency mortgage market is a seven trillion dollar market. And while there is technically a little bit of risk in some of the mortgages guaranteed by Fannie Mae and Freddie Mac, for the most part, investors assume that these bonds have no credit risk. And so the risk that you're taking is prepayment risk, because in the U.S., the homeowner has the ability to refinance or pay off their mortgage whenever they want. So the investor is short that option. And right now, we think a lot of these options are kind of fully priced into the market in agency mortgages and we're recommending an underweight to agency mortgages.
Jim Egan: We talked a little bit about supply and demand in the housing market earlier. I hear a lot about quantitative easing and through the quantitative easing program, the Fed is buying a lot of mortgages, isn't it something in the neighborhood of 40 billion dollars per month? Shouldn't that kind of marginal demand for mortgages be really positive? Why exactly are we underweight?
Jay Bacow: So that's a good point. And the Fed's buying 40 billion mortgages on a net basis. They're buying about 120 billion mortgages on a gross basis. That is a lot of demand. But, Jim, you talked about the strength of the housing market. There's even more supply. Last year had the highest supply to the mortgage market on record. This year with mortgage rates where they are, we expect a roughly similar number. And I think what's different about the mortgage market versus these other markets is that there's a catalyst for it to reprice. And in fact, there’s two catalysts. The first is the supply that we already mentioned, but the second are those options that you're short as an investor to the homeowner and prepays. When we talk about stock valuations or credit valuations, it's easy to point to one or two simple numbers that you know. In mortgages, you have to make an assumption about what the odds are that the homeowner is going to refinance. And with mortgage rates at the all time low, the models are having a difficult time predicting what the likelihood is of those homeowners refinancing. And with that greater uncertainty, combined with the supply that's coming to the market, that argues for wider spreads. And lastly, we'll point out, you just described a lot of attractive investments in the resi-credit complex. We think investors would be better suited to move out of agency mortgages despite its liquidity advantage and into opportunities like residential credit or corporate credit, where we see more attractive upside and more carry from wider spreads.
Jim Egan: That all make sense. Jay, always great speaking with you.
Jay Bacow: Jim, it was a pleasure. Thank you.
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