Housing activity was one of the main casualties of the rise in interest rates with total home sales down more than a third since early 2022 (see chart 1). As we noted before, the rise in interest rates has eroded affordability for homebuyers but did not trigger debt-servicing problems for homeowners as in the run-up to the financial crisis.1 As a result, home prices have held up well despite the plunge in home sales (see chart 1 again).
Source: US Census, NAR, S&P Global and FHFA2
In our view, the discrepancy between homebuyer and homeowner conditions is likely to last a while longer, keeping supply tight, sales volumes low and prices well supported.
Housing scarcity, which is also reflected in stubbornly high rent inflation,3 could increasingly become a political issue and create a policy dilemma for the Fed.
Housing-related assets, however, benefit from the current situation. Given our outlook, we believe that Agency Credit Risk Transfers (CRT) offer the best value in the form of high coupons and moderate default risk. In our view, the potential for further spread narrowing looks limited but the value proposition remains attractive with selected opportunities across the capital structure.
We have constructed two indices that characterize the conditions of homebuyers and homeowners. We define homebuyer conditions as a function of housing affordability and availability and homeowner conditions as a function of actual mortgage-service payments, housing wealth and labor market conditions.4
Source: US Census, Freddie Mac; Board of Governors of the Federal Reserve System, U.S. Bureau of Economic Analysis, BIS and own calculations.5
Chart 2 shows the two indices of homebuyer and homeowner conditions. The two indices are at the extreme opposite sides of the range over the last 40 years. High current mortgage rates and housing prices plus low housing supply squeeze potential homebuyers out of the market, while home- owners feel little pressure given low unemployment, low service payments for existing mortgages as well as high housing wealth.6
The extreme divergence between homebuyer and homeowner conditions has a paralyzing impact on the housing market since most of the housing supply comes from existing homeowners.7 At the moment, homeowners have little incentive to sell their existing homes and buy new ones as the service payments for new mortgages are in most cases significantly higher than for existing mortgages.8
The supply of newly-built homes has increased by a third since the start of Covid, but that has not been sufficient to offset the short-fall in the supply of existing homes.9 As a result, the total inventory of homes for sale has dropped by a quarter since the start of Covid and is currently close to the lows since the start of the century (see chart 3).
Source: US Census and NAR10
The dispersion between homebuyer and homeowner conditions and, thus, the low supply of homes for sale is neither likely to last forever nor likely to reverse quickly. The last time homebuyer conditions improved rapidly and homeowner conditions deteriorated sharply was after the bursting of the housing bubble (see chart 2 again). This is unlikely to happen now as there are no signs of excess leverage and construction activity in the housing sector as was the case prior to the financial crisis (see chart 4).
Source: Board of Governors of the Federal Reserve System, U.S. Bureau of Economic Analysis & ZAIS estimates11
To be sure, other events could trigger a deep recession with soaring unemployment and rapidly falling interest rates and lead to a reversal in housing market conditions. We cannot rule out such possibility but think that this is a low probability outcome.
Last year, we predicted that house-price-appreciation (HPA) would most likely move to zero by the end of this year with a bull/bear scenario range of +/-10%.12 The latest data suggests that HPA will probably settle between our base and bull scenarios by the end of the year.13 Looking ahead, we see again three scenarios but with a narrower range and a positive bias (see chart 5).
Source: FHFA and own estimates14
The current housing environment is also bad news for tenants as potential buyers who cannot afford or find a house are forced to rent.
The overall housing shortage in the face of solid household growth15 could increasingly become a political issue that plays a role in the run-up to the elections next year and increases the pressure on policy makers including the Fed to act. Indeed, the Fed could find itself in an uncomfortable position as our analysis suggests that monetary tightening (if it falls short of triggering a recession) is hurting the supply of housing more than its demand and could, thus, compound rather than ease house-price and rental inflation.
Tight housing supply and rising house prices, while bad news for homebuyers, are positive for housing-related assets.16 This is supported by homeowners’ sound financial and employment conditions17 as well as the massive improvement of credit risk scores for new mortgages since the financial crisis (see chart 6).
Source: New York Fed18
From an investment perspective, we think Agency CRTs are the best way to take exposure to housing-related assets. Agency CRTs transfer the “first loss” credit risk of underlying GSE mortgage pools to investors and pay in return a coupon.19 In our view, Agency CRTs pay a high premium for relatively moderate default risk.
CRT coupons move in line with the Fed funds rate and on balance doubled since early 2022 to over 10% (see chart 7).
Source: Board of Governors of the Federal Reserve System and JPMorgan20
Actual mortgage delinquencies, however, have remained low (see chart 8).
Source: Board of Governors of the Federal Reserve System and New York Fed21
In our view, delinquencies are likely to move a bit higher next year but only a deep recession could erode homeowner financial and employment conditions so much that defaults would wipe out the compensation offered by current CRT coupons, which we cannot rule out but do not think has a significant probability.
Besides the fundamental value proposition (high coupon versus low default risk), we also see a technical argument in favor of Agency CRT, namely falling issuance. After a surge in the first half of 2022, Agency CRT issuance started to decline in the second half of 2022 and continued to move lower this year.22
We see two factors behind this development. First, Agency MBS issuance itself has declined sharply in line with the overall fall in housing activity (see chart 9).
Second, in an effort to reduce the costs related to the CRT program Agencies are repurchasing CRT notes that have significantly deleveraged and no longer provide a financially attractive means of transferring credit risk23 The incentive to repurchase CRT notes increases with rising house prices which reduces effective leverage ratios (LTV).
2023 is through October and the figures in parenthesis are the % changes from the respective period a year earlier.
Source: JPMorgan24
Agency CRTs performed well this year. After a bumpy ride in 2022 when the market adjusted to higher interest rates and increased CRT issuance, spreads narrowed on average by 270 basis points over the last 12 months, making Agency CRTs one of the best performing assets this year (see chart 10).
Source: JPMorgan25
Going forward, we think the scope for further spread tightening and, thus, price increases is limited. However, we believe the fundamental value proposition remains in place (i.e., high coupons for modest default risk). In our view, there are select opportunities across the capital structure.
On a spread basis, we believe investors are very well compensated in investment grade tranches given protection against modification or credit losses. We also think that select B2 bonds at the most subordinate level of the capital stack that are two or more years seasoned benefit from accumulated HPA gains and supply scarcity and should continue to perform well.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
The information presented here has been prepared and provided by and is confidential and proprietary to ZAIS Group, LLC and its affiliates and subsidiaries (collectively, “ZAIS,” “we,” “us,” or “our.”). Accordingly, this material is not to be reproduced in whole or in part or used for any purpose except as we have authorized, is to be treated as strictly confidential and is not to be disseminated, communicated or otherwise disclosed directly or indirectly to any party other than the recipient. If you have received the presentation in error or by other means, it must be destroyed and by no means circulated, copied or otherwise duplicated or disseminated without the express permission of ZAIS. By accepting receipt of this document, the recipient agrees to comply with this restriction and confirms its understanding of the limitations set forth in these disclaimers.
This information is being delivered only to a limited number of eligible recipients who are limited to “accredited investors” and “qualified purchasers” (as such, or similar, terms are defined in U.S. federal securities laws), “sophisticated investors”, “qualified investors”, “institutional investors”, “wholesale clients”, “professional clients” and/or “eligible counterparties” (as such, or similar, terms are defined in other jurisdictions). In particular, this information is not intended for recipients who do not meet the foregoing standards (in the relevant jurisdiction) and in no circumstances will this information be made available to “retail” clients or investors in any jurisdiction. This information may only be provided to recipients that are experienced in making investments of the sort described here, are seeking risk adjusted returns in the investments they make, are capable of sustaining a complete loss of the principal amount invested and are capable of investing across any time horizon to which an investment may be subject.
The information contained in this presentation does not purport to be all-inclusive or to contain all the information a prospective client or investor may require. This presentation may include various statements, charts, graphs, and other financial information, views, estimates, and beliefs that are forward-looking or non-factual (collectively, “Statements”). Unless otherwise noted, the source of information for such Statements is ZAIS. Additional information is available on request.
Statements constitute only subjective views, beliefs, outlooks, estimations, opinions or intentions as of the date(s) shown, which are subject to change due to a variety of factors, including fluctuating market and business conditions. These Statements are necessarily based upon speculation, expectations, views, estimates and/or assumptions made by ZAIS with respect to past or future events and anticipated future operations and performance, are inherently unreliable and are subject to significant business, economic and competitive uncertainties, known and unknown risks and contingencies, many of which cannot be predicted or quantified and are beyond the control of ZAIS. Certain Statements contained here represents ZAIS’s current reasonable opinion based on unaudited and forecast figures which have been derived from multiple sources and have not been subject to specific due diligence. No representation is made that such Statements are now, or will continue to be, complete, timely or accurate in any way. ZAIS accepts no liability whether in contract, tort or otherwise for (1) the information not being full and complete, (2) the accuracy of any opinion, (3) the basis on which any comparison has been drawn or the facts selected to make such comparison and (4) the assumptions underlying any opinions. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements. In light of these risks and uncertainties, there can be no assurance or representation that these Statements will prove to be accurate, timely or complete in any way. Statements may constitute “forward-looking statements” within the meaning of the Securities Exchange Act of 1934. They may be prefaced by or subject to terms such as “anticipate” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “seek,” “approximately,” “may,” “plan,” “potential,” “should,” “would” and “will” or the negative thereof or other variations thereof or comparable terminology. The recipient of this information is cautioned not to place undue reliance on forward-looking statements. This presentation may include a current executive summary of ZAIS, copies of our recent news releases, and reports by securities analysts or others. Opinions, forecasts, projections or other Statements expressed in those reports are the responsibility of the analysts, journalists and/or the firms they represent and do not necessarily represent our views. Any third party’s report included in this presentation is provided for information purposes only and is not to be construed as indicating our agreement or disagreement with anything contained there. Statements made here that are not attributed to a third-party source reflect our views and opinions. While the information provided here is believed to be accurate and reliable, no representations or warranties are made as to the accuracy, timeliness or completeness of such information and we undertake no obligation to update or revise the presentation. In furnishing this presentation, we reserve the right to amend or replace some or all of the information here at any time and undertakes no obligation to provide the recipient with access to any additional information, or to update, or to correct any inaccuracies which may become apparent in this presentation or any other information made available.
This information has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any ZAIS vehicle which may or may not be made available. Any such offer of securities would, if made, only be made pursuant to definitive, final private offering documents (of which this presentation is not a part), which would contain material information not contained here (including certain risks) or material that differs from the information contained here and to which current and prospective investors are referred. Any decision to invest should be made solely in reliance upon such definitive, final private offering documents. In the event of any such offering, this information shall be deemed superseded, amended and supplemented in its entirety by such definitive, final private offering documents. Prospective investors should carefully consider the risk warnings and disclosures set forth there and here. Information contained here does not purport to be complete and is subject to the same qualifications and assumptions, and should be considered by investors only in the light of the same warnings, lack of assurances and representations and other precautionary matters, as disclosed in an applicable private offering memorandum and subscription agreement. No representation or warranty can be given with respect to the terms of any offer of securities conforming to the terms hereof. There is no guarantee that the strategies set forth here will be successful. Any securities issued will be issued pursuant to a private placement exemption and will not be registered under the Securities Act of 1933, as amended, or the laws of any state or other jurisdiction and will be subject to substantial restrictions on sale and transferability.
This presentation may include statements and information that relate to subjective viewpoints as well as, among other things, potential future events, plans, projections, transactions, and assets, including related future assumptions. All such statements and information, other than of historical fact, included in this presentation are, as applicable, forward-looking, constitute only subjective views, expectations, beliefs, outlooks, predictions, estimations or intentions, should not be relied upon and are subject to change. Actual events or results may differ materially. These statements and information are based upon assumptions, beliefs and analyses made on the basis of subjective perception of historical trends, current conditions and expected future developments, as well as other factors that ZAIS believes are appropriate in the circumstances. Statements may constitute “forward-looking statements” within the meaning of the Securities Exchange Act of 1934. They may be prefaced by or subject to terms such as “anticipate” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “seek,” “approximately,” “may,” “plan,” “potential,” “should,” “would” and “will” or the negative thereof or other variations thereof or comparable terminology. These forward-looking statements include, among other things, projections, forecasts, estimates or hypothetical calculations with respect to income, yield or return, future performance targets, sample or pro forma portfolio structures or portfolio composition, scenario analysis, specific investment strategies or proposed or proforma levels of diversification or sector investment. These statements are necessarily based upon speculation, expectations, views, estimates and/or assumptions made by ZAIS with respect to past or future events and anticipated future operations and performance, are inherently unreliable and are subject to significant business, economic and competitive uncertainties, known and unknown risks and contingencies, many of which cannot be predicted or quantified and are beyond the control of ZAIS. Prospective investors are cautioned not to place undue reliance on such statements. No representation is made by ZAIS as to the accuracy, validity or relevance of any such forward-looking statement and the recipient agrees it is solely responsible for gathering its own information and undertaking its own projections, forecasts, estimates and hypothetical calculations. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these statements. All forward-looking statements included here are based on information available as of the date indicated and ZAIS does not assume any duty to update any forward-looking statement contained here. Some important factors which could cause actual results to differ materially from those in any forward-looking statements include, among others, the actual composition of the investment portfolio, any defaults in or to the investments, the timing of any defaults and subsequent recoveries, changes in interest rates, changes in currency rates and any weakening of the specific obligations included in the portfolio. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual returns or results will not be materially lower or higher than those presented. The value of any investment, and the income from it, may fall as well as rise. Accordingly, there can be no assurances that an investor will receive back all or any of the original capital invested. Further, investments may be leveraged, and the portfolio of investments may lack diversification thereby increasing the risk of loss.
Certain information contained herein represents ZAIS's current reasonable opinion and is based on unaudited and forecast figures which have been derived from multiple sources and have not been subject to specific due diligence. The information has been provided in good faith but is not guaranteed and is subject to uncertainties beyond ZAIS's control and should not be relied upon for the purposes of any investment decision. ZAIS makes no representations or warranties and accepts no liability whether in contract, tort or otherwise for (1) the information not being full and complete, (2) the accuracy of any opinion, (3) the basis on which any comparison has been drawn or the facts selected to make such comparison and (4) the assumptions underlying any opinions. ZAIS does not undertake to update its opinions. No opinion of this nature can be, and this information does not purport to be, full, complete, comprehensive or to contain all relevant information. Statements made herein that are not attributed to a third party source reflect the views and opinions of ZAIS.
ZAIS Group (UK) Limited is a company registered in England with number 08908933 and whose registered office is at c/o Dixon Wilson, 22 Chancery Lane, London WC2A l LS, United Kingdom. ZAIS Group (UK) Limited is an appointed representative of Infinity Asset Management LLP, which is authorized and regulated by the Financial Conduct Authority in the United Kingdom. ZAIS Group UK Limited’s FCA status as an appointed representative of Infinity Asset Management LLP does not imply a certain level of skill or training. Investors will not benefit from the rules and regulations made under the Financial Services and Markets Act 2000 for the protection of investors, nor from the Financial Services Compensation Scheme in the United Kingdom. Nothing here excludes any liability which ZAIS is not permitted to exclude by applicable law.
ZAIS Group, LLC’s registrations with the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”), and ZAIS Group (UK) Limited’s status as an appointed representative of Infinity Asset Management LLP, which is regulated by the United Kingdom’s Financial Conduct Authority (“FCA”), does not imply a certain level of skill or training.
There can be no guarantee that responsible investing products or strategies will produce returns similar to or better than other strategies we manage. An environmental, social and governance (“ESG”) strategy restricts the types and number of available investments and prioritizes the ESG criteria over other investment criteria. Consequently, an ESG portfolio may perform differently from other strategies that do not screen for ESG factors. Responsible investing is qualitative and subjective by nature, and there can be no guarantee that the criteria we use, used or will use, or decisions we make, made or will make, will reflect any particular investor’s beliefs or values. We source some of the information we use in identifying responsible investments from voluntary or third-party reporting, which may not be accurate or complete. Responsible investing standards may vary by region. There can be no assurance that the responsible investing strategy and techniques we employed will be successful. Investors should be prepared to risk the loss of some or all of the capital invested in the ESG strategy.