- We believe the US housing market will continue to benefit from the structural tailwinds of rising rates of household formation and prolonged undersupply of new homes since the crisis.
- Affordability will be a headwind until wages rise further and/or if interest rates resume their upward climb after their late-2018 retreat.
- We expect housing market activity and home-price appreciation to slow in response to higher interest rates; however, in our opinion today’s more disciplined underwriting of mortgages reduces the likelihood of defaults stemming from overextended borrowers.
- We are expressing our constructive view of US housing through investments in non-agency residential mortgage-backed securities (RMBS), particularly credit risk transfer securities.
- The importance of security selection has been heightened by the proliferation of rating agencies covering the RMBS sector, which sometimes causes identically rated securities to carry differing levels of risk.
As has been widely noted in the media, generally rising interest rates (with a sizable reversal as 2018 drew to a close) and historically high prices have begun to erode housing affordability in the United States. Home sales and building activity are slowing, raising concerns about the housing sector’s outlook. Activity may slow further in the near term as Americans adjust to lofty prices and higher mortgage rates (the recent drop in rates at the end of 2018 should help).
Yet in our view, housing is responding to reduced affordability in a reasonable and disciplined way. Although soft housing activity can detract from economic growth and weigh on home-builder stocks, the performance of residential mortgage-backed securities (RMBS) is more closely tied to home-price appreciation, which we expect to persist.
Our outlook for the US housing market remains constructive based on continued muted supply, supportive demand trends, and affordability that even after setbacks is still at the high end of its historical range. We are expressing this positive view through investments in non-agency RMBS.
DETERIORATING AFFORDABILITY: A HEADWIND
Home prices have surged in recent years as demand has outpaced supply. But appreciation has begun to slow as homeownership affordability has declined — albeit from lofty levels. Affordability, which is based on median home prices, household income, and mortgage rates, has been slipping in recent years. This is mainly due to a steady rise in home prices averaging more than 5% annually over the last several years, as reported by S&P/Case Shiller, and to increases in mortgage interest rates; at 31 December 2018, the 30-year fixed mortgage rate was about 0.6% higher than a year ago according to bankrate.com. (We note, however, that mortgage rates fell along with the drop in interest rates in late 2018 — a decline that, if sustained, would likely reverse some of the downward pressure on affordability.)
These two trends have hindered both home sales and home-building activity. Figure 1 shows that housing affordability broadly (dark blue line) has dropped about 30% since 2013, but is still above its long-term average and well above pre-crisis levels. We see a similar trend for first-time home buyers (light blue line) with affordability returning to a more normal range, though still elevated versus history. We believe that continued low unemployment and rising wages will help offset some of the downward pressures on affordability.
Figure 1: Affordability has receded, but is still high by historic norms
A composite index reading of 100 means a family earning the median income has the exact amount needed to purchase a median-price home using conventional financing. The first-time home-buyer index measures the ability of potential first-time buyers to qualify for a mortgage on a starter home. An index reading of 100 means the first-time buyer can afford the typical starter home under existing financial conditions with a 10% down payment. Higher index readings signal a greater likelihood that potential home buyers can afford to purchase. | Sources: Bloomberg, National Association of Realtors | Period of data: 31 December 1998 – 30 September 2018
DEMAND SHOULD CONTINUE TO OUTWEIGH SUPPLY
Over the long term, home prices are driven by supply and demand dynamics, which we believe are supportive into the foreseeable future. It is true that demand has softened recently as declining affordability has prompted consumers to pause and reassess their home-buying options. However, we think favorable demographic trends will keep demand strong over the medium-to-long term. Household formation is on the rise as millennials, who had only about a 35% homeownership rate in 20161, represent the second-largest generation in the US and are just entering their prime homeownership years. At the same time, the lengthening life expectancies of the largest generation, baby boomers, is keeping them in their homes longer, limiting a potential source of housing supply.
On the supply side, the market is dealing with a lack of inventory, especially for smaller/starter-type homes. The stock of available existing homes is low, though up slightly from a decades-long trough at the end of 2017; the supply of new homes is a bit higher, but still relatively muted (Figure 2).
Figure 2: The inventory of homes is close to historic lows
Months supply is the ratio of houses for sale to houses sold in a month (single or average). Sources: Bloomberg, National Association of Realtors, US Census Bureau | Period of data: 31 January 1999 – 31 October 2018
According to recent data from the National Association of Realtors, the price of a median new home is about 30% more than the median existing home, versus historical premiums averaging roughly 10% – 20%. Rising costs for materials, labor, and land have made it more expensive to build homes, and the higher premium has placed new construction out of reach for many first-time home buyers. Until home builders can deliver a product at a price point attractive for entry-level buyers, we expect these tight supply conditions to remain in place. Home builders can shift their strategies toward constructing more entry-level housing, but we think it will take a long time before the market sees any significant supply uptick in that segment.
TIGHT CREDIT STANDARDS HAVE GREATLY ENHANCED THE QUALITY OF TODAY’S MORTGAGE LOANS
When affordability deteriorates, banks tend to loosen their underwriting standards in order to maintain loan volume. While there has been some loosening of credit, it is not nearly as pronounced as it was in the past. Stricter federal regulations (notably, qualified mortgage and ability-to-repay rules enacted after the financial crisis) and more conservative capital market conditions have discouraged lenders from making loans to borrowers whose debt-to-income ratio exceeds 43%. This can be a difficult hurdle for many first- time home buyers who may carry other substantial debt such as student loans, auto loans, and credit card balances. Stricter lending terms have also limited the amount of leverage borrowers can take on when purchasing a home.
Since underwriting hasn’t loosened materially during this cycle, we believe credit availability is unlikely to significantly shrink from here — lowering the odds of a substantial housing correction in the near-to-medium term.
EXPECT HOME-PRICE GROWTH TO MODERATE, BUT REMAIN POSITIVE
As consumers take time to recover from the initial shock of higher mortgage rates and home prices, they will likely shift their focus to more affordable homes and rental properties. This should cause the current gap in demand between existing homes (more affordable) and new homes (less affordable) to widen. Additionally, the combination of rising interest rates, lack of inventory, and tight credit availability will likely result in lower housing turnover going forward. We expect home-price appreciation to moderate but still exceed wage growth, with constrained supply and robust demand overshadowing lesser affordability.
Prospects for continued home-price appreciation, along with strong underwriting standards that have vastly improved the quality of today’s mortgage loans, make post-crisis non-agency RMBS one of our current top investment ideas.
COMPELLING OPPORTUNITIES IN RMBS BACKED BY LOW-TO-MIDDLE-TIER HOUSING
We believe RMBS performance is strongest when supported by both improving collateral valuations and healthy borrowers. For this reason, Fannie Mae and Freddie Mac agency credit risk transfer (CRT) securities have been a favored investment of our Securitized Investment Team. These agency CRT deals are backed by loans on low-to-middle-tier homes, which we believe are poised to outperform high-end homes as a result of better supply and demand dynamics and relatively greater affordability compared to newly built homes, which skew to the higher end.
As discussed earlier, the shortage of housing inventory in the US is particularly acute at the entry level (Figure 3). The pronounced imbalance between supply and demand in this segment, along with affordability that is still better than any period in the pre- crisis era, provides a positive backdrop for this part of the market, benefiting the performance of both bonds and collateral credits. In addition, today’s mortgage loans — those financing starter homes as well as other housing segments — are originated under some of the most conservative underwriting criteria seen in decades, and they expose investors to much lower credit risk than past cohorts. This bolsters our conviction that CRT securities will hold up well in an economic downturn.
Figure 3: Supply is even tighter in low-income housing Months supply of existing homes for sale, by price point
Source: Zelman Associates
SECURITY SELECTION IS VITAL
Wellington’s Financial Reserves Management Investment Team, which focuses on managing portfolios for asset owners with special regulatory and accounting requirements such as insurers, favors a variety of post-crisis non-agency RMBS. For insurance companies, we are finding value in below-investment-grade CRTs issued by Fannie Mae and Freddie Mac that come with a top NAIC (National Association of Insurance Commissioners) designation. We believe these securities provide an attractive opportunity to add yield without increasing capital charges for these institutions. For clients who need long-duration assets, we prefer prime jumbo RMBS backed by pristine borrowers.
We are wary, however, of the proliferation of rating agencies covering US RMBS deals, which has resulted in a notable increase in the number of split-rated bonds, and in single-rated bonds rated by less-established rating agencies. This means that two bonds rated identically by different agencies could carry significantly varying levels of risk. An issuer can often reduce its all-in cost of financing by “shopping” agencies and choosing the one that has assigned its bond issue the highest rating. (This practice appears to be less prevalent in CRT deals, which are typically rated by three major rating agencies.) A recent report published by Fitch compared the home-price declines that a BBB- rated bond must be able to withstand in order to maintain its investment-grade rating, by agency (Figure 4).
Figure 4: The size of home-price declines triggering write-downs on BBB- bonds varies by rating agency
Based on the most recently rated low-loan-to-value GSE credit risk transfer transactions that closed prior to 30 June 2018 | Sources: Fitch Ratings, Case Shiller, Fannie Mae, Freddie Mac, transaction presales as reported by rating agencies
The differences were stark, ranging from the roughly 20% home-price depreciation required by some agencies, to just 8% by another. Subjecting a bond rated BBB- only by Rating agency “F” to a -20% home-price shock would result in a severe, if not total principal loss, whereas a bond with the same BBB- rating, but assigned by Rating agency “A” or “B,” could survive virtually unscathed. This divergence reinforces the key role of proprietary fundamental research, independent of rating- agency assessments, in determining the riskiness of heterogeneous RMBS collateral pools.
Our outlook for US housing remains favorable, based on continued constraints on supply, strong demand, and still-supportive affordability. This expectation of continued home-price appreciation is key to our positive view of the RMBS sector. That said, we believe that recent softening in the sector warrants close monitoring of market conditions and heightens the importance of security selection.