Housing Finance Post Covid-19 Is In Better Shape Than You Think
In the world of mortgage investors, the glorified days of the Salomon Brothers trading desk, with stories of John Gutfreund, Lew Ranieri and games of liar’s poker, are a distant memory. Instead, scars from the global financial crisis endure in hearts and minds. The painful memories include the collapse of Bear Stearns and Lehman Brothers and the implosion of America’s mortgage finance and housing sectors.
For better or worse investors in mortgage securities, like investors in other markets, look to the past to forecast the future. In the wake of the pandemic-led market convulsions, some now worry of the history of 2008 repeating itself in mortgage credit and housing. I believe such fears are ill-founded. To be sure, higher default rates and weaker housing prices are likely in the near term. However, I view the odds of a dire 2008-like scenario as remote.
As a manager of portfolios of residential mortgage credit, I often get questions about this asset class and the housing market from investors, homeowners and prospective home buyers. Today many people are trying to sort out what the surge in unemployment means for mortgage credit and housing values. Their questions typically take one of two forms: Does the near-term horizon threaten a 2008-sized contagion of mortgage defaults and housing depreciation? Or is this time different? In fact, this time is very different from prior down cycles, especially 2008.
Homeownership represents a major investment for most homeowners. Looking back through different recessionary periods, home prices have often proven resilient, especially when aggregated on a national level. In contrast, the credit meltdown of 2008 led to a 35% national decline in home prices. Some regions in the Southwest and Southeast dropped more than 50%. Thus 2008 was an anomaly among past down cycles rather than a precedent for the future. Furthermore, given shelter-in-place efforts to slow the spread of COVID-19, never in recent history has the home been so important to our daily lives.
Home prices are largely driven by a combination of supply/demand dynamics and affordability. In the months and years leading up to the global financial crisis, all these metrics were aligning – firing on all cylinders like a Formula One race car, just before careening out of control on the speedway. The supply of homes skyrocketed as homebuilders hit records on new housing starts. This activity was spurred by a flood of new entrants into the housing market.
Much of this demand came in response to affordability juiced up by the loosening and even virtual abandonment of underwriting standards and Wall Street financial wizardry. The national homeownership rates tracked by the U.S. Census Bureau diverged from the long-term national average of 65%, rising upwards of 69% by mid-2004. To paraphrase the character Gale Boetticher, Walter White’s unfortunate superlab assistant in the television series “Breaking Bad,” that last four percent may not sound like a lot. But it was.
As recession took hold in 2008, banks teetered, Americans lost their jobs, and mortgage payment defaults began to climb. Mortgage borrowers typically default for understandable reasons: they lose their job or succumb to one of the “Three Ds”: death, divorce or disease. None are happy events, but these nevertheless are the “normal” causes of default. The global financial crisis brought us a brand-new breed of delinquent borrowers: the “strategic defaulters.” Due to the abundance of alternative-document and subprime mortgages, these borrowers put down little to no equity to buy their homes. The famous NINA (No Income, No Asset) loan, which later came to be notoriously known as the NINJA (No Income, No Job, No Assets), is just one example of the underwriting craziness of the time.
As home prices fell borrowers with little or no equity abandoned their homes, dumping more inventory on a foreclosure supply already growing from “normal” defaults. Why pay my mortgage when I can rent the house next door for half price? Perhaps a decade prior such a decision might have stigmatized the strategic defaulters among their social groups and neighbors, but this practice became accepted by societal norms during the global financial crisis. In fact, how not to pay your mortgage and still live in your house was a common topic at cocktail parties, much like the tech stock tips of the late 1990s.
The abundance of new homes for sale combined with the flood of foreclosures swelled the available housing stock, leading to a vicious collapse in home prices as demand and affordability contracted with the economic recession and dramatic tightening of lending standards.
In the days leading up to the COVID-19 pandemic and population lockdown, the housing and mortgage markets were quite different. In the beginning of this year the supply of existing homes for sale was near 35-year lows, with shortages particularly acute at the entry-level portion of the market. Housing starts struggled during the post-crisis decade of the 2010s as home builders contended with increased labor, material and land costs. Instead, home builders tended to focus on high-priced homes with higher margins and on multifamily building to meet the “urbanization” demand as millennials flocked to large cities for employment.
In the summer of 2016, with economic growth, demand for single-family homes was increasing, lifting the homeownership rate toward its long-run average of 65% from its lows of 62.9%. De-urbanization had already begun in response to the rising cost of living and rents in cities. For example, according to a study by the national rental listing service RENTCafé, average rent here in Los Angeles has increased by 65% to $2,527 over the past 10 years.
As the millennial generation ages, forms households and has children, the migration to the suburbs will continue. I can attest to this phenomenon myself as a child of the early 1980s and now the father of three children under five years of age. In addition, demand has increased from institutional investors, especially with the growth of the institutional single-family-rental buyers such as real estate investment trusts (REITs) like American Home 4 Rent and Invitation Homes.
Source: Morgan Stanley, Current Population Survey/Housing Vacancy Survey (U.S. Census Bureau)
The housing market was humming along as 2020 began. The credit quality of new loans as measured by average credit scores of borrowers and the down payment required by lenders were significantly higher than during the years leading into 2008. In fact, borrower home equity was near all-time highs as home prices had steadily risen by 64% from their 2012 lows, and borrowers had been paying down the principal on their mortgages at an increasing rate relative to the prior decade due to low interest rates.
Source: Federal Reserve Bank of St. Louis (Economic Research Division)
Then came COVID-19 and the shock of economic shutdowns. Unemployment surged, accompanied by an equally dramatic drop in growth. What does this mean for home prices? We must re-visit the supply/demand dynamic and affordability.
Take existing low levels of inventory for sale, remove homes from the market as sellers seek to shelter-in-place, and you have a continued lack of supply. The wave of foreclosures that drowned the market in supply during the global financial crisis is now postponed by forbearance programs. The Coronavirus Aid, Relief, and Economic Security (CARES) Act allows borrowers to miss up to 12 monthly mortgage payments without damaging their credit scores, providing time to work with their servicers to make up payments in the future. Additionally, with high levels of home equity (“skin in the game”), there should be few strategic defaulters. In fact, the home is now perhaps more important than ever.
The immediate spike in unemployment has hurt homeowners less than renters. Homeowners on average are more likely to have white-collar jobs, higher median incomes and higher savings. Furthermore, an acceleration in de-urbanization has driven a near-term spike in demand in certain areas. Families are looking for more space as working from home becomes a more permanent, even attractive reality for some rather than a temporary, suboptimal solution. I know many financial firms that are quite surprised at the efficiency of their telecommuting workforce.
Even before the pandemic and shutdowns, years-long price appreciation in the housing market was starting to diminish affordability. Nevertheless, affordability remained above the long-term average given low mortgage rates. The current crisis will withdraw access to credit as lenders tighten their underwriting boxes in anticipation of job losses and related defaults. However, this should be offset by historically low mortgage rates, perhaps balancing the affordability equation.
While prices of homes will decline due to the economic contraction, the favorable supply/demand dynamics and continued affordability – particularly relative to renting – should prevent the collapse of home prices seen during the global financial crisis. Certain regions will be hit harder than others. High-priced homes in high-tax states are especially vulnerable. Some of those markets had already begun to weaken due to changes in state and local tax (SALT) deductions from 2018. Vacation and second home destinations seem more at risk than primary homes. Suburban areas nearest jobs-rich urban centers should weather the storm the best, as was the case during the last recession.
I wish the best health and happiness to everyone and their families during these trying times as a nation and people. May the summer bring us warm weather, a revival of the economy, and positive news for the future.
Ken Shinoda is a portfolio manager on the mortgage-backed securities team at DoubleLine Capital, LP, a Los Angeles-based asset manager.