Are We About to See the Shortest Housing Cycle Ever?

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1:16Hello and welcome to another episode of the Oddbots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, do you remember this time last year, some of the discourse around the housing market? Yeah, of course. I mean, this was like really like when people were like waking up to these sort of like eye-popping mortgage rates, at least by recent standards, you know, zoom out, maybe not that high, but by recent standards, like, oh, this is it. Housing is sort of over, crash, prices plunge, we're back. That's exactly it. So we had a really historic run up in benchmark interest rates, and those were translating into higher mortgage rates.

1:53And everyone thought that this was going to lead to a, you know, some people thought it would be a house price collapse. Others thought it would be some sort of impact, something significant one way or the other. And yet, fast forward 12 months, I'm looking at the Case-Shiller index. We had a tiny dip, relatively small, going into the end of last year, and now house prices are rising again. We basically hit like the shortest housing bear market ever. Yes. Like it's a really tiny dip in prices. Every index you mentioned, I saw some other one just yesterday, like one of those like national like Friday ones.

2:35I don't know. That's like rocketing up again. Obviously, we know that like the home builders sort of like slammed the brakes. So it's like, OK, here's prices falling. Buyers drop out. Home builders get crushed. Their stocks are, as we've been talking about on a bunch of recent episodes, they're like basically at all time highs. So somehow this huge repricing of mortgages did not cause the housing bear market that many, but not everyone expected. Yeah. And I mean, it's bad news if you were hoping that house prices would collapse, that you could finally enter the market. Good news if you are a homeowner, potentially.

3:09But anyway, you remember we talked to a guest last year. I think it was last October. And the idea was basically we were getting this really weird housing market. with rates going up, but house prices actually not that vulnerable to a decline. And I think that scenario has more or less panned out. Totally. And it's been a theme of a few episodes, but it's totally true, which is that a precondition, so to speak, of like a real housing downturn is unemployment and the existence of forced sellers. And so it's not a very good time to buy, but also very few people are forced sellers other than, I think we like talking about their divorces and things like that, or people who have to move for their work.

3:53But this has manifested itself not just in firm prices, but no housing inventory. And the people who track levels of housing inventory, it's like record lows are close to it. And so, yeah, demand has dropped with high mortgage rates, but so has supply, and you get your price stability. That's right. So on this episode, I am very pleased to say we are going to be doing a checkup of the weird housing market. Let's put it that way. We're going to be speaking again with Jim Egan. He is, of course, the U.S. housing strategist over at Morgan Stanley. So, Jim, thank you so much for coming back on All Thoughts.

4:28Thank you for having me back. It's a pleasure to be here. So, since we last spoke, I've been following your research, and your thesis when we spoke was this idea of basically a subdued impact on house prices, maybe less housing activity itself. Since then, you've sort of ratcheted down your expectations for house prices and then ratcheted them back up, not by a huge degree, I should say. But walk us through what the past 10 months or eight months or so have been like from your perspective, trying to gauge what's going on here. Right. So I think you two both brought up a lot of kind of the key underlying points for how we think about the housing market.

5:09Our general framework, we like to call it our four-pillared framework where we're talking about demand for shelter, supply of shelter, the affordability of the U.S. housing market, and the availability of mortgage credit. But a lot of what's been going on has been this kind of juxtaposition between supply and affordability. Mortgage rates move incredibly higher, and we see affordability deteriorate at a pace unlike anything that we've ever really seen in 2022. But the key question to ask on the back of that is, who's affordability actually just deteriorated? And the structure of the mortgage market this time around is such that you have what we'll call strong hands.

5:50A lot of homeowners were able to either buy their home or refinance their mortgage at record low rates. And so they have these 30-year fixed-rate mortgages where they're just incentivized not to list their home for sale. And so, Joe, you mentioned that inventories are close to historic lows. We have existing listings going back over 40 years, and we're pretty much at the lows right now. And so if you don't have those homes listed for sale, then all of a sudden, despite the fact that affordability might theoretically warrant lower home prices, homeowners aren't willing to sell or they're not forced to sell into those lower home prices that affordability might theoretically warrant.

6:31Of the inventory that exists, how much of it is people who are selling for some reason or another? Because there is some selling, it's not none. Versus the role of new supplies, so basically new homes. When we think of inventory, we break it down across three lines, right? Existing listings, new home builds, and then you have kind of what we call the shadow inventory. This is distressed. This is your forced sellers. This is foreclosures, right? We're going to put that to the side for this conversation because we do think that mortgage credit standards, that fourth pillar, they've been so robust.

7:03They've remained so tight in the aftermath of the great financial crisis that we just don't necessarily see a substantial increase in defaults and foreclosures coming. Now, from a new home sales perspective versus an existing home sales perspective, a new listings perspective versus an existing listings perspective, this is still largely going to be an existing listings market, right? New home sales, one of the characteristics over the past six months of this year has been the fact that new home sales have made up a larger percentage of total transaction volumes since 2006 versus existing. However, that just means they've climbed back to about 20 % of transaction volumes.

7:43So existing listings are still, call it 80 % of those monthly transactions, even if those listings are kind of running at 40-year lows. So one of the interesting things that's happened in recent months is the home builders seem to have really ramped up activity, which is somewhat unusual because you would assume with interest rates going up, their cost of capital would be increasing. And yet it seems that supply is still so tight that everyone wants to get in on building new houses. How big of a surprise has that been for you? And would you expect the new home building response to moderate at some point?

8:23So I think if we take a little bit of a step back and look at the total starts figures, because I agree, if we look at some of the housing data that's come across in the past month, the past two months, I'd say that the three data points, if you wanted to grab an optimistic housing view, would be do home sales. Wait, what's optimistic? Yeah, is that house prices going up or down? I don't even know what the optimistic side is anymore. That's a good question. I guess if you want to say that we're going to enter, I don't even want to call it a V-shaped recovery, but a significant increase in housing activity and then potentially even an increase in home prices on the back of that, as opposed to maybe an L-shape.

9:02Have we found the bottom and we're moving? Or another leg down. So if you wanted to grab a, we're entering a recovery, activity is going to increase, sales and starts are going to increase, prices are going to increase. By the way, these are not our forecasts. You would grab new home sales, you would grab housing starts, and you would grab home builder confidence, right? Those are the ones that have been increasing. I mentioned already new home sales making up a larger share of transactions than really any point since 2006 to begin this year. That, we think in part, is helping home builder confidence increase.

9:34It's climbed every single month for the first six months of this year after falling in every single month of 2022. But one thing that we would say here is a growth in new home sales is not necessarily indicative of a growth in the overall demand for shelter. That housing starts number. We think we have to take a step back and look at it in terms of single unit and multi-unit, right? Single unit starts have historically made up, call it 70 to 80 % of that number. They're a slightly smaller share of that total number now as multi-unit has made up a bigger share. From peak in this cycle, in April of 2022, single unit starts are down over 20%.

10:13Now, the rate of that decline has slowed in recent months. And one of the reasons that we think that builders are also turning a little bit more optimistic is the backlog of homes under construction has been able to clear. That built throughout last year, supply chain issues related to the pandemic, labor constraints. It just took longer to finish homes. As starts have come down, units under construction have come down. From peak units under construction are down about 125, 130 ,000 units. That's not the case on the five-plus unit construction side. Units under construction continue to grow, and the numbers that have beat expectations recently, we still think that multi-unit is driving the bus there.

10:55May of this year, remove all seasonal adjustments. May of this year, we saw more five-plus unit starts than any month since 1986. Wow. I think it was this conversation that we had last year, and I learned a bunch of terms that I had only pretended to know before, like headship rates and how you measure household formation. So I really appreciate you. I really appreciated that because I finally got to learn a few things. But one of the things that we did see, especially during the sort of like the pandemic boom, weirdly enough, the 2021, the sort of surge in household formation, people leaving their roommates, people moving out of, you know, maybe moving out of their parents' house, like the sort of like 2010s cliche of like living in your parents' basement, et cetera.

11:38What are we seeing in like current trends of household formation? I think that's one of the key questions to where we're moving going forward. And I will caveat this by saying the data here is a little lagged. We are starting to see it slow. For all the trends that you just mentioned, household formation really increased over the course of the past three years. If I was on this podcast in 2019 and we were talking about demographics and what they would have meant for household formation going forward, we would have said that demographics warrant 1.3 to 1.4 million formations per year for at least the next five.

12:19Okay. The last three years, we've seen something closer to 1.8 million. Wow. Yeah. You mentioned headship rates. If we don't think that headship rates systemically should have moved higher, they certainly have over the last three years. But if you don't think that longer term they're moving higher, that means that we've pulled forward, if our original numbers were somewhere close to correct, call it 1.2 to 1.5 million households. Wait, just real quickly. I know I said I learned last year on the podcast what headship rates are, and now I forget. What's a headship rate again? So a headship rate, when you look at the population, you break it down by whatever cohorts you want to.

12:53Let's just do it by age. So a headship rate is if you take everybody who's call it 25 to 29 years old, picture a 25-year-old. They're living in an apartment with three other people. The headship rate of that very small four-person cohort, 25%. If all of them move to their own apartments, all of a sudden you have four people heading – Exactly. Okay. And so typically headship rates for that early to mid-20s, you're talking 25-ish percent. And through your late 20s, early to mid-30s, they climb to the 55 percent. So household formation is a verb and headship rate is a noun kind of, or stock versus flow may be one way to think about it.

13:31Stock versus flow, yes. So I realized I should have asked you this directly at the beginning of the conversation, but what is your base case forecast for house prices? Yes. And so you did talk about a little bit of oscillation in what we were calling for. When I came on in October, we had brought our end of 2023 number down to minus 3 % year over year. We have just raised that. We're back to flat 0.0 by the end of the year. And that is despite the fact that we continue to see in our forecasts a handful of months of negative year over year prints. We just did. So the Case-Shiller number for June, it's two months lagged.

14:06It's April data. It's the first time they've turned negative year over year since 2012. we think that's going to be short-lived. It's going to be a couple months. It was only about 24 basis points negative. And we think by the end of the year, we're going to be back to flat. I just want to say, when we had you out in October, there was an out of consensus. I mean, people - Yeah, it was. I think you deserve a lot of credit. It got a lot of pushback and then it turned into the consensus, basically. But like, it really did. Like, at the time, this was, it was a real out of consensus call. And I think that we should like, sort of take a moment to recognize.

14:39And that's, you know, that's why we have you back. But that was like at that time, people most of thought you were crazy.

14:48Listeners can't see Jim's face, but he's thinking how to respond. First of all, thank you. There were certainly a lot of conversations in the fourth quarter of last year that asked why we weren't calling for home prices to fall further. Yeah. I would say that you made the comment that it moved towards consensus. It certainly did. And I don't think that our 0 % call by the end of the year is too far from consensus right now.

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17:18Because I know you mentioned that you have this sort of four pillar way of looking at the housing market. I think the four factors are supply, demand, affordability, and credit availability. And then there's also this question of unemployment, which seems to be a big one sort of hovering over the industry or the market as a whole. So what are you looking at as the biggest risk factor to your outlook? Tracy, I think you mentioned a really good factor here from the unemployment perspective. But I want to take a step back and frame this in terms of the risks to the call to the upside and the risks to the call to the downside.

17:55We do think that if we're wrong, it's because home prices ended up climbing more than we expect by the end of the year. And we think that because, look, affordability still remains incredibly low, close to multi-decade lows. And so if you were to see affordability start to improve, and perhaps it improves because maybe we get more of a soft landing than we're expecting. Maybe the labor market starts to slow down, doesn't necessarily fall off a cliff. If maybe inflation really starts to slow down and all of a sudden you get a world in which perhaps the Fed can start cutting earlier than people expect, rates start to come down.

18:32Affordability is largely a three-pronged declaration. It's incomes, it's rates, and it's home prices. And if rates start to come down, yes, affordability is going to be very difficult for that to get back to where we were in the 2020-2021 timeframe. frame. But if people start seeing 5.5 % mortgage rates as opposed to 7%, that could bring more people off the sidelines and supply is still going to be low. Jay Bacow and our agency MBS team calculate something called the Truly Refinanceable Index. And I do think this is one of the more important numbers in our forecast, or at least interesting. It measures what percentage of the mortgage universe has at least a 25 basis point incentive to refinance at any given point in time, given where prevailing rates are.

19:16As we're sitting here today, it's less than 2 % of the universe. If mortgage rates were to rally all the way to 4%, that is nowhere close to our forecasts. If they get to 6 % by the middle of next year, we think that would be roughly in line with expectations that might be higher than that. But if they get to 4%, that truly refinanceable index only climbs to 21 % of the mortgage market. 79 % of mortgaged homeowners have a mortgage rate of three, three and a half percent, they're not going to be incentivized to list their homes as these rates start to come down. So you could get this demand reaction into what is still an incredibly tight supply environment that leads to upside risk to our call.

19:58Interesting. So the demand variable just seems way more potent than the supply variable. On the upside. On the upside. Downside. Yeah. Now we're looking at supply. Okay. If you don't necessarily see an improvement in affordability, if you do get a harder landing than we think, if the unemployment rate picks up, and so all of a sudden you do have issues that remain there from the demand side, and you have some impetus for supply to start being delivered into this lower demand environment, that's where you could start to see home prices come down. Because of where lending standards have been, we don't think it's going to be defaults and foreclosures.

20:36You anticipated where I was going to ask, because I imagine, so we're at like 3.6 % unemployment. Like, you know, there's a world where like it goes over four and a half or five, you know, I don't know. But like, I imagine that let's say that went up to 5 % in a recession, that that would have much less of an impact on housing supply than an equivalent move in the year 2007 with so many of the, you know, ninja loans and variants. I couldn't have said it better myself. One of the huge differences, you mentioned Ninja Loans, just the overall structure of the mortgage market, the percentage of the mortgage market that were adjustable rate.

21:17You had mortgages that were resetting into a lower home price environment and a tighter lending standard environment. So that monthly payment was increasing. Those homeowners effectively needed to refinance that mortgage, and it was really difficult for them to access that credit. which meant a larger, a large share of mortgages falling delinquent. This time around, not only do you not have that lending environment, you have a much stronger just mortgage base. On top of that, servicers have a much more robust toolkit, if you will, foreclosure mitigation options, modifications, servicers working to help borrowers stay in their homes.

21:59That wasn't something that we as an industry had had a whole lot of experience with in 2008. Servicers are much more comfortable with that now. Right. I forgot all those stories of people trying to get their banks on the phone even. I just had big flashbacks to writing a lot about the HAMP modification program post-2008. But now we have blueprints for doing these sort of modifications or loan forgiveness. Yeah, somehow to stave off the wastefulness and the costliness of a foreclosure. But since you mentioned banks and credit availability, we have seen some banking drama this year. And there was some talk initially that concerns around bank portfolios and maybe banks preparing for higher capital regulation or requirements was going to lead to less willingness to underwrite mortgage credit.

22:59Is there any evidence that we're seeing that or is that something that's on your radar? It is definitively on our radar. We've done a lot of work under an umbrella that we've kind of called a new regime for bank assets for the reasons that you're mentioning. We do anticipate more regulation either being proposed or announced through the end of this year where regulations like LCR, liquidity coverage ratios, TLAC, total loss absorbing capital, banks away from the GSIBs having to have their mark-to-market losses unavailable for sale securities moving through to their regulatory capital, which they could have opted out of up until what we believe these proposals will look like.

23:41All of that, we think, means they have to hold more cash effectively. They have to have a higher level of liquidity. It means they're going to have less dollars to lend. It also means they're probably going to be looking a little bit more shorter duration on the asset side. And banks buy a lot of mortgage-backed securities. By our estimates, banks hold about 33 % of the agency MBS universe. They buy that as longer-duration assets. So we do think that that's going to impact mortgage rates from that perspective. When we originally thought through this, again, Jay Backow, the agency strategist, he went underweight mortgages because this is a structural change to bank demand for mortgages on a go-forward basis.

24:21But valuations matter as well. So we're neutral at this point. Mortgages did sell off. And so we think that at this point, they're effectively fair value. But that is how we kind of have to think about affordability moving forward. And then from a credit availability perspective, if you ask where from a four pillar perspective we were in that outlook the last time I was here versus now, I would have told you that we probably expected lending standards to ease at least on the margins over the course of 2023. We no longer believe that. Lending standards, we think, if anything, they'll stay tight, probably going to tighten from here.

24:55Some of the credit availability indices are already showing a little of that behavior. But lending standards have remained so tight for 15 years. The question is really how much tighter can they get? I want to talk about another dynamic of the sort of pandemic housing boom. You know, we talked about the surge in household formation and roommates no longer being roommates and people moving out of their families' homes. The other thing we saw is people with high incomes leaving cities and going into markets in which they had above average income. So if you're working for Facebook or something and suddenly you can like go live, you know, in Arizona or Utah or whatever, and suddenly you're the highest paid person in the area, you can outbid all the locals for homes.

25:37Obviously, that wave ended probably reversing a little bit, and then some companies are like, no, we actually don't want you out in the middle of nowhere, come back to the office, et cetera. How much did that sort of distort things and contribute to price appreciation? And how much is this sort of like, I guess it's like ameliorating some of that wave affecting the market now? So from a contribute to price appreciation perspective, if you ask me the one data point I really want to know for home prices six or 12 months forward, it's supply. If you ask me five years forward, it's population migration and where people are moving.