At GAM Investments’ latest Active Thinking forum, Tom Mansley assesses the current situation in the US housing market and discusses the ongoing appeal of seasoned mortgage-backed securities.
Tom Mansley, Mortgage-backed securities (MBS)
The US mortgage market is significant in size; over USD 10 trillion, larger than the corporate bond market. There are two ways to access this market; one is government guaranteed mortgages and the other is through credit.
We prefer seasoned credit of mortgages issued prior to the 2008/9 crisis (over 15 years ago) as they offer stable cash flows. These mortgages belong to people that have been in their houses for a long time, have demonstrated an ability to pay, and have a lot of equity in their homes. As a result, it is a very stable underlying asset and is largely uncorrelated with credit sensitive assets.
The most popular mortgage by far is the 30-year fixed rate mortgage. As such, rate rises do not have as much of an impact on mortgage credit in the US as many homeowners have fixed rate mortgages; it is not a floating rate regime as in some other parts of the world where payments rise as rates rise.
What is going on in housing markets?
Currently one of the most common questions we are asked is if mortgage rates are high, why have there been few defaults and why are home prices not falling? Many are concerned that high rates and unaffordable houses could result in another crash. However, as we have been saying for a while, we expected some pullback followed by a stabilisation because there is a large supply/demand imbalance. In the US, the vacancy rate, the number of empty houses, is at a 60-year low. There is a very constrained supply, with not a lot of inventory.
In terms of demand, we look at how many new households are forming every year and how many new houses are built every year. Since 2009, there has been far more demand for housing than houses being built. This has been the case for so long because millennials have not been buying houses, choosing to rent instead. As a result, there is currently a lot of pent-up demand among a big demographic slice of society.
Since the mid 2000s, millennials often opted to rent in order to live in cities so they did not buy homes. However, as they began to have children, they needed to buy houses. The home buying trend began around 2016 before accelerating during Covid. Now, they are buying despite rising rates because they need to purchase houses and they have the income and savings to do so. A large demographic slice of a country delayed buying a house for about 10 years; that is a lot of demand to be made up for and that is what is keeping house prices where they are today, which is equal to the peak of June 2022.
Why MBS now?
Spreads are wide on a historic basis, generating 300+ bps of extra yield on top of Treasuries resulting in a yield of approximately 7.5%. In addition to the running yield, it is also reasonable to expect some capital gains going forward when spreads do normalise.
Why are spreads wide?
There is a fear associated with mortgages. In many places, there is a floating rate regime which is a real problem; mortgages can reset higher and it becomes more difficult for homeowners to make the repayment, causing a consumer credit problem. Meanwhile, in the US, the Fed raising rates has little impact on the homeowner.
Our seasoned residential mortgage-backed securities (RMBS) have a strong loan to value ratio and spreads should not be as wide as they are, in our view. Spreads are going to be brought down by a demonstrated non-default concept; that is to say, as they continue to perform well they will drift back in.
One of the supporting factors that we think will prevent mass defaults is the unemployment rate. It is below 4%, which is historically very low. Unemployment could increase substantially to reach ‘normal’ unemployment. which is why the Fed is not concerned about unemployment – it is just too low and inflationary. Everyone has a job, payments are small, and therefore delinquencies are low. People are also sitting on a lot of excess savings accumulated during Covid. Delinquencies will probably rise slightly but only because they are so low right now; we are well below the norm.
Another reason spreads should come in is that people are sitting on 3% mortgages and do not want to move, so there is not a lot of turnover. On average, turnover is 6%, and goes up to 8% in good times. Now it is going lower than 6%. As turnover gets lower, the supply of RMBS is going to be lower. There are no more seasoned mortgages, and while there is a secondary market, it gets smaller and smaller every day. This lack of RMBS supply should drive spreads to narrow going forward.
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