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ZAIS Insights

Housing slump supports Agency CRT notes

By Bernhard Eschweiler, PhD3 minute read

  • Homebuyer and homeowner conditions diverge sharply …
  • … undermining home sales but supporting house price appreciation
  • Agency CRTs offer good value for housing-related exposure

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).

Chart 1: Home sales and prices / 
        Million units saar (lhs); Jan-2020=100 (rhs)
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.

Paralyzing housing conditions

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

Chart 2: Homebuyer and homeowner conditions / Index 100=neutral, >100=favorable
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).

Chart 3: Total homes for sale / Million units sa
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).

Chart 4: No housing excesses / Index 100=neutral, >100=excess
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.

House prices likely to rise further

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).

Chart 5: House price appreciation / % change over 4 quarters
Source: FHFA and own estimates14

  • Base scenario: The situation remains broadly unchanged, in particular, 30-year mortgage rates stay around 7% and the inventory of total homes for sale remains in the current low range (see chart 3 again). In this scenario, we estimate that HPA will stabilize around 5% in the course of next year.
  • Bull scenario: Soft-landing allows the Fed to cut interest rates and improving housing demand more than offsets increases in housing supply. In this scenario, we estimate that HPA will rise to 10% in the course of next year.
  • Bear scenario: The economy slips into recession, but with moderate unemployment increases (up one or two percentage points). The Fed cuts interest rates yet housing demand stays muted, while housing supply increases. In this scenario, we estimate that HPA will decline to zero in the course of next year with a small chance of turning negative.

Political issue and dilemma for the Fed

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.

Not so bad for housing-related assets

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).

Chart 6: Credit scores of new mortgages / % share of mortgages with 760+ credit risk score
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).

Chart 7: Fed funds rate and CRT coupons / % p.a.
Source: Board of Governors of the Federal Reserve System and JPMorgan20

Actual mortgage delinquencies, however, have remained low (see chart 8).

Chart 8: Single-family mortgage delinquency rates / % of total balance
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.

CRT supply declining

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).

Chart 9: Net Agency MBS issuance / $ billion, all fixed-rate MBS
2023 is through October and the figures in parenthesis are the % changes from the respective period a year earlier.
Source: JPMorgan24

Moving down the CRT credit curve

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).

Chart 10: Average Agency CRT cashflow spread / Basis points over swaps
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.

More Information

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

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Endnotes

  1. The Big Housing Correction,” ZAIS Insights, September 2022.
    https://www.zaisgroup.com/the-big-housing-correction.html
  2. U.S. Census Bureau and U.S. Department of Housing and Urban Development, New One Family Houses Sold: United States [HSN1F], retrieved from FRED, Federal Reserve Bank of St. Louis; November 27, 2023.
    https://fred.stlouisfed.org/series/HSN1F
    National Association of Realtors, Existing Home Sales [EXHOSLUSM495S], retrieved from FRED, Federal Reserve Bank of St. Louis; November 27, 2023.
    https://fred.stlouisfed.org/series/EXHOSLUSM495S
    Monthly FHFA House Price Index® for Census Divisions and U.S.; Purchase-Only Index;
    https://www.fhfa.gov/DataTools/Downloads/Pages/House-Price-Index-Datasets.aspx#mpo
    S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index [CSUSHPINSA], retrieved from FRED, Federal Reserve Bank of St. Louis; November 13, 2023.
    https://fred.stlouisfed.org/series/CSUSHPINSA
  3. U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Shelter in U.S. City Average [CUSR0000SAH1], retrieved from FRED, Federal Reserve Bank of St. Louis; November 16, 2023.
    https://fred.stlouisfed.org/series/CUSR0000SAH1
  4. Home-buyer conditions consist (equal weighted) of the debt-servicing payments of new mortgages, house prices relative to disposable income and the home vacancy rate. Home-owner conditions consist (equal weighted) of the debt-servicing payments of existing mortgages, house prices relative to disposable income and the unemployment rate
    The data sources for the homebuyer conditions index are:
    U.S. Census Bureau and U.S. Department of Housing and Urban Development, Median Sales Price of Houses Sold for the United States [MSPUS], retrieved from FRED, Federal Reserve Bank of St. Louis; November 13, 2023.
    https://fred.stlouisfed.org/series/MSPUS
    U.S. Census Bureau, Median Family Income in the United States [MEFAINUSA646N], retrieved from FRED, Federal Reserve Bank of St. Louis; November 13, 2023.
    https://fred.stlouisfed.org/series/MEFAINUSA646N
    Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; November 12, 2023.
    https://fred.stlouisfed.org/series/MORTGAGE30US
    U.S. Census Bureau, Homeowner Vacancy Rate in the United States [RHVRUSQ156N], retrieved from FRED, Federal Reserve Bank of St. Louis; November 6, 2023.
    https://fred.stlouisfed.org/series/RHVRUSQ156N
    The data sources for the homeowner conditions index are:
    Board of Governors of the Federal Reserve System (US), Mortgage Debt Service Payments as a Percent of Disposable Personal Income [MDSP], retrieved from FRED, Federal Reserve Bank of St. Louis; October 27, 2023.
    https://fred.stlouisfed.org/series/MDSP
    Bank for International Settlement; Nominal and real residential property prices including historical data previously published in the long series data set; October 25, 2023.
    https://www.bis.org/statistics/pp_selected.htm?m=208
    U.S. Bureau of Economic Analysis, Disposable Personal Income [DSPI], retrieved from FRED, Federal Reserve Bank of St. Louis; November 13, 2023.
    https://fred.stlouisfed.org/series/DSPI
    U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; November 8, 2023.
    https://fred.stlouisfed.org/series/UNRATE
  5. See footnote 3.
  6. See data references footnote 3.
  7. In the 10-years before Covid, existing homes accounted for 90% of the total housing inventory for sale. U.S. Census Bureau and U.S. Department of Housing and Urban Development, New One Family Homes for Sale in the United States [HNFSEPUSSA], retrieved from FRED, Federal Reserve Bank of St. Louis; November 6, 2023.
    https://fred.stlouisfed.org/series/HNFSEPUSSA
    National Association of Realtors, Existing Home Sales: Housing Inventory [HOSINVUSM495N], retrieved from FRED, Federal Reserve Bank of St. Louis; October 23, 2023.
    https://fred.stlouisfed.org/series/HOSINVUSM495N
  8. Based on our calculations, interest rates for new mortgages are currently about double of the average effective interest rate on existing mortgages.
    Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; November 5, 2023.
    https://fred.stlouisfed.org/series/MORTGAGE30US
  9. U.S. Census Bureau and U.S. Department of Housing and Urban Development, New One Family Homes for Sale in the United States [HNFSEPUSSA], retrieved from FRED, Federal Reserve Bank of St. Louis; November 6, 2023.
    https://fred.stlouisfed.org/series/HNFSEPUSSA
    National Association of Realtors, Existing Home Sales: Housing Inventory [HOSINVUSM495N], retrieved from FRED, Federal Reserve Bank of St. Louis; October 23, 2023.
    https://fred.stlouisfed.org/series/HOSINVUSM495N
  10. Total homes for sales is the sum of new homes for sale and existing homes for sale.
    U.S. Census Bureau and U.S. Department of Housing and Urban Development, New One Family Homes for Sale in the United States [HNFSEPUSSA], retrieved from FRED, Federal Reserve Bank of St. Louis; November 27, 2023.
    https://fred.stlouisfed.org/series/HNFSEPUSSA
    National Association of Realtors, Existing Home Sales: Housing Inventory [HOSINVUSM495N], retrieved from FRED, Federal Reserve Bank of St. Louis; November 27, 2023.
    https://fred.stlouisfed.org/series/HOSINVUSM495N
  11. U.S. Bureau of Economic Analysis, Private Residential Fixed Investment [PRFI], retrieved from FRED, Federal Reserve Bank of St. Louis; November 8, 2023.
    https://fred.stlouisfed.org/series/PRFI
    Board of Governors of the Federal Reserve System (US), Households and Nonprofit Organizations; One- to-Four-Family Residential Mortgages; Liability, Level [HHMSDODNS], retrieved from FRED, Federal Reserve Bank of St. Louis; November 8, 2023.
    https://fred.stlouisfed.org/series/HHMSDODNS
    U.S. Bureau of Economic Analysis, Disposable Personal Income [DSPI], retrieved from FRED, Federal Reserve Bank of St. Louis; November 8, 2023.
    https://fred.stlouisfed.org/series/DSPI
  12. “The Big Housing Correction”; ZAIS Insight; Chart 8; September 2022.
    https://www.zaisgroup.com/the-big-housing-correction.html
  13. Based on S&P/Case-Shiller and FHFA, HPA was 2.6% and 5.6% respectively in August 2023.
    Monthly FHFA House Price Index® for Census Divisions and U.S.; Purchase-Only Index;
    https://www.fhfa.gov/DataTools/Downloads/Pages/House-Price-Index-Datasets.aspx#mpo
    S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index [CSUSHPINSA], retrieved from FRED, Federal Reserve Bank of St. Louis; November 13, 2023.
    https://fred.stlouisfed.org/series/CSUSHPINSA
  14. Monthly FHFA House Price Index® for Census Divisions and U.S.; Purchase-Only Index;
    https://www.fhfa.gov/DataTools/Downloads/Pages/House-Price-Index-Datasets.aspx#mpo
  15. U.S. Census Bureau, Household Estimates [TTLHHM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; November 6, 2023.
    https://fred.stlouisfed.org/series/TTLHHM156N
  16. Rising house prices increase the value of home equity directly but also lower the effective loan-to-value ratio of mortgages and, thus, reduce the potential write-off in case of a default.
  17. Board of Governors of the Federal Reserve System (US), Households; Owners' Equity in Real Estate as a Percentage of Household Real Estate, Level [HOEREPHRE], retrieved from FRED, Federal Reserve Bank of St. Louis; November 5, 2023.
    https://fred.stlouisfed.org/series/HOEREPHRE
    Board of Governors of the Federal Reserve System (US), Mortgage Debt Service Payments as a Percent of Disposable Personal Income [MDSP], retrieved from FRED, Federal Reserve Bank of St. Louis; October 27, 2023.
    https://fred.stlouisfed.org/series/MDSP
    U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; November 8, 2023.
    https://fred.stlouisfed.org/series/UNRATE
  18. Federal Reserve Bank of New York Consumer Credit Panel/Equifax; Quarterly Report on Household Debt and Credit, Q3 2023
    https://www.newyorkfed.org/microeconomics/hhdc
  19. “CRTs are issued by the GSEs as unsecured debt obligations. Unsecured refers to the fact that these debt obligations are not backed by any form of collateral and as such represent a greater threat to the buyer in that they might not be able to recover their investment. To offset this risk, unsecured debt obligations typically carry higher interest rates and are structured as credit-linked notes (a financial security specifically designed to transfer credit risk). The GSEs pay interest on these notes (coupon) and repay principal based on the performance of an underlying pool of loans. The GSEs choose the underlying loan pool at their discretion, although the typical choice is fixed-rate single-family loans with a loan-to-value (LTV) ratio exceeding 60 percent. If this loan pool incurs losses, the value of the notes is written down and the GSE is no longer obligated to pay that portion of the principal to its investors, shifting the burden of any loss to the investors. This puts the GSEs in a ”last loss” rather than ”first loss” position with respect to many of the loans that they guarantee.“
    Credit Risk Transfers: A Primer; Thomas Kingsley; AAF; November 10, 2020.
    https://www.americanactionforum.org/insight/credit-risk-transfers-a-primer/
  20. Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [DFF], retrieved from FRED, Federal Reserve Bank of St. Louis; November 7, 2023.
    https://fred.stlouisfed.org/series/DFF,
    JPMorgan Markets, Data Query
    https://markets.jpmorgan.com/#dataquery,
    retrieved MBS/Mortgage Credit/MBS Credit Index, CRT latest Coupon.
  21. Board of Governors of the Federal Reserve System (US), Delinquency Rate on Single-Family Residential Mortgages, Booked in Domestic Offices, All Commercial Banks [DRSFRMACBS], retrieved from FRED, Federal Reserve Bank of St. Louis; October 24, 2023.
    https://fred.stlouisfed.org/series/DRSFRMACBS
    Federal Reserve Bank of New York Consumer Credit Panel/Equifax; Quarterly Report on Household Debt and Credit, Q3 2023
    https://www.newyorkfed.org/microeconomics/hhdc
  22. CRT issuance jumped from $14 billion in 2021 to $22 billion in 2022 and is expected to decline to $10 billion this year. Non-Agency MBS Weekly; BofA Securities; Securitized Product Strategy; November 10, 2023.
    https://rsch.baml.com/report?q=TiJCeGk0FWp1-veJ8UXsmQ
  23. Repurchase of STACR Notes; Freddie Mac Backgrounders; November 3, 2023.
    https://capitalmarkets.freddiemac.com/crt/resources/backgrounders/repurchase-stacr-notes
  24. JPMorgan Markets, Data Query
    https://markets.jpmorgan.com/#dataquery,
    retrieved MBS/Agency MBS/Issuance/Agency fixed.
  25. JPMorgan Markets, Data Query https://markets.jpmorgan.com/#dataquery,
    retrieved MBS/Mortgage Credit/MBS Credit Index, CRT latest Cash Flow Spread to Swaps.

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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.

Regulatory Registrations and Authorizations

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.

ESG/Responsible Investing

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.