The U.S. housing market experienced a reset last summer when rapid home price appreciation (HPA) and historically low mortgage financing costs shifted abruptly. The resulting affordability constraints from elevated mortgage interest rates have dampened consumers' inclination and ability to own larger homes away from major cities. S&P Global Ratings expects the U.S. housing and mortgage markets to continue to slow in 2023 due to the uncertain timing of the Federal Reserve's monetary policy pivot and the economic appeal of renting instead of buying a property. The slowing housing market is not entirely unexpected because the pandemic-related home price gains of roughly 40% since the second-quarter of 2020 were unsustainable.

Our 2023 residential mortgage and housing outlook examines the competing effects of renting versus owning, market variables and home prices, the shallow expected rise in delinquencies, the sharp drop in U.S. residential mortgage-backed securities (RMBS) issuance, and the ongoing popularity of investor-owned residential properties and their footprint in the non-agency securitization market.

How Low Can Prices Go?

As the housing market corrects in 2023, home-price forecasts vary across the industry. Some expect declines in excess of 10%, while others forecast small increases of 1% to 2%. Fannie Mae expects prices to decline 4.2% nationwide. Real estate brokerage and trade association groups tend to have rosier forecasts. After mortgage rates spiked in 2022, the change in the seasonally-adjusted Federal Housing Finance Agency (FHFA) Purchase-Only Index between the peak level in June 2022 and October 2022 was just negative 1.06%. Surprisingly, the seasonally cooler months (which tend to exhibit lower demand relative to the warmer months) did not contribute much to the 1.06% decline in home prices. The non-seasonally-adjusted June to October change was approximately negative 2.06%, but the August to October period contributed little to this decline.

It takes time for interest rate changes to percolate through the economy, especially the housing market. So it's possible that the full impact of the recent interest rate hikes on house prices is yet to come. That said, the recent economic landscape resembles that of the early 1980s, when high inflation, tightening monetary policy, and back-to-back recessions caused HPA to enter negative territory for several quarters. Interestingly, the average rental vacancy rate at that time is similar to the current rate, which is roughly 6% (see chart 1). These patterns suggest that home price trajectories in 2023 could undergo a similar experience to that of the early 1980s.

Chart 1

We expect the average 30-year fixed-rate mortgage will be above 6% during 2023, which would continue to strain affordability. We also believe home prices could depreciate about 5% this year, based on an extrapolation from the peak of seasonally-adjusted FHFA purchase-only data reached last summer. When the 30-year fixed-rate mortgage exceeded 17% in both the fourth-quarter 1981 and first-quarter 1982, the non-seasonally-adjusted quarterly FHFA All-Transactions Home Price Index (HPI) declined roughly 1.2% in each quarter. The economy in 1982 saw unemployment of almost 10%, which is considerably higher than the 4.9% average we forecast for 2023. In any case, the near doubling of mortgage rates within a span of six months in 2022 delivered a greater payment shock than in 1981, when rates, although high, increased proportionately much less (from 15% to nearly 18%).

The current housing market correction has much to do with affordability and the economics of whether to rent or own property. Historically low mortgage rates, coupled with the pandemic effects of 2020 and 2021, incentivized buyers. The benefits of the single-family floorplan (versus that of a multifamily unit) combined with remote working increased the utility of homeownership and strengthened the economic decision to buy. The household formation among the large millennial demographic group was another key factor.

The housing market shifted last year when the monthly cost of owning surpassed that of renting, based on our assumptions and calculations (see chart 2). Owning has typically been economically optimal, and this was consistently the case throughout the 15 years leading up to 2022. The cost gap between renting and owning was widest during the pandemic when the 30-year fixed-rate mortgage hovered just below 3%. Now that renting appears optimal from a monthly payment perspective, mortgage rates may have a greater influence on housing market dynamics than they did during previous housing cycles. Although both rents and house prices face downward pressure in 2023, renting will likely remain more economically and psychologically appealing this year, which would support the investment property segment of the housing market.

Chart 2

Non-Agency Issuance Will Decline

We expect overall non-agency securitization issuance of approximately $85 billion in 2023. This represents a 40% decline from the roughly $140 billion issued in 2022, and a more than 50% drop from the $190 billion issued in 2021, due to volatility in the mortgage finance market. We also expect that higher interest rates, which drove the market slowdown in the second half of 2022, will reduce refinance activity and purchase volumes. Fannie Mae's January Housing Forecast puts single family originations at roughly $1.6 trillion in 2023--a 30% decline relative to 2022. We forecast that non-qualified mortgage (non-QM) RMBS issuance will lead issuance at approximately $25 billion, and we expect credit-risk transfer (CRT) and single-family rental (SFR) to have relatively stable issuance activity. Combined, we expect issuances from these three subsectors to represent more than half of the $85 billion RMBS issuance forecasted for 2023 (see chart 3).

Chart 3

Our 2023 forecasts for the six non-agency RMBS subsectors are as follows:

• Prime (jumbo and conforming): We expect jumbo and agency-eligible loan issuance to decline considerably this year due to higher mortgage rates and the volume contraction of agency-eligible investor loans that have found favorable execution in the non-agency space.
• SFR: The acquisition of new assets (homes) will likely contract this year. However, SFR issuance volume should be somewhat insulated from the contraction due to required refinancing (structural mechanics incorporate balloon loan maturities) and because this subsector generally relies on securitization for funding.
• CRT (including mortgage insurance): We expect purchases to represent most originations this year versus refinance and cash-out transactions, and conforming loans with high loan-to-value (LTV) ratios should support CRT activity. Our forecast reflects the depth of the CRT primary and secondary bond markets and the corresponding agency goals to shed credit risk, despite the expected decline in residential mortgage originations this year. The recent FHFA increase in the conforming loan balance should also support CRT issuance.
• Reperforming and nonperforming: Interest rates may temper issuance in 2023, although a recession in the first half of the year could increase the number of mortgages with adverse payment profiles and provide mortgage pool supply.
• Non-QM: Given the financing dependencies of the securitization market for non-QM and mortgagors' lower rate sensitivity in general, we expect non-QM issuance volume to decline, commensurate with the roughly 30% expected drop in national residential mortgage originations. DSCR investor loans continue to represent a growing share of the non-QM space.
• Other: This category includes issuances backed by assets such as servicer advances, residential transition loans, mortgage servicing rights, and reverse mortgages. It also includes closed-end second-lien and HELOC loans, which could contribute to a higher forecast volume for this segment, depending on the momentum of these programs and their use within the non-agency securitization market. Because these other securitization types may, in the aggregate, be unaffected by market conditions in 2023, we don't expect a material difference in issuance activity compared with 2022.

Support For Investment Properties

Although financing costs have broadly increased, origination volumes of DSCR investor loans have been largely stable, and the proportion of these loans in non-QM transactions remains strong (see chart 4). We will continue to monitor the performance of the rental market, as well as short-term rental platforms such as Airbnb, which have flourished in recent years. In the event of a recession, areas with high concentrations of short-term rental properties may feel increased pressure if regional travel and leisure suffer, and incomes cannot support local home values.

Despite the modest decline in SFR issuance in 2022, a growing portion of homebuilder inventory, which would have typically been sold through traditional retail transactions, may make its way to investors via build-to-rent communities, thus supporting SFR issuance this year. Given the housing market fundamentals and the low rental vacancy rate shown in chart 1, SFR securitizations appear to have strong operating cash flow, despite decelerating rent growth, general expense increases, and rising financing costs. We believe the SFR subsector could partially accommodate higher financing costs for bond issuance without a concurrent increase in operating yield, given the rise in HPA for the properties in the underlying portfolios. Although agency-eligible-investor non-agency RMBS issuance has likely dried up, we believe non-QM (due to DSCR investor loans) and SFR may be relatively strong contributors in 2023. SFR also provides exposure to the residential housing market without the convexity profile of traditional RMBS.

Chart 4

Will Recessionary Effects Fuel Delinquencies?

Securitized residential mortgage performance exhibited resilience in 2022. Although inflationary effects spread throughout the U.S. economy last year, performance metrics indicate that mortgagors escaped largely unscathed (see chart 5). This could be attributable to two factors: first, rising costs had limited impact on homeowners because household savings increased during the pandemic; and, second, rising prices had a minimal effect on monthly principal and interest mortgage payments because most loans were locked in at low interest rates, making the mortgage a strong inflation hedge. Also, the tight labor market and low unemployment rate in 2022 contributed to good RMBS performance, and the typical homeowner has seen strong home equity "paper gains" over the past 30 months.

A recession in 2023 would likely have a negative effect on labor markets. Rising unemployment--especially in the white-collar sector--and the resulting reduction in obligor cash flow could lead to increased delinquencies, even though home equity positions may be strong in many cases. There is also some indication that the household savings built up during the pandemic have since eroded under inflationary pressure. However, given the strong home equity positions and our forecast for peak unemployment at only 5.6% this year, we don't expect a repeat of the Global Financial Crisis (GFC)--especially given the improved mortgage underwriting in the post-GFC era. Moreover, the generally good home equity positions may lead to non-adverse resolutions of borrower defaults.

Chart 5

With comparatively low purchase volume, low housing supply, and a forecast mortgage rate above 6% for 2023, conditional prepayment rates (CPRs) will likely remain subdued in 2023. Low CPRs are generally credit-negative for non-agency RMBS because they reduce capital structure deleveraging. The baseline mobility CPR will likely remain below historical levels. This could be exacerbated if the shift to permanent remote work becomes a secular change. The geographic representations within mortgage pools will also influence transaction performance as certain areas across the country experience greater housing pressure.

2023 Housing At The Local Level

The U.S. housing market is approximately 20% overvalued, in our view, based on regional price-to-income ratios compared to historical norms (a feature we embed in our credit analysis by adjusting the loss severities, see "Overvaluation May Be Peaking: How It Affects U.S. RMBS," published Oct. 17, 2022). Although this year's themes for the U.S. housing and mortgage markets are similar at the national level, there has been significant variation in HPA and overvaluation at a geographically granular level in recent years. As the pandemic weakens and employers bring people back to the office, certain regions may face excess inventory, especially in areas that saw substantial population migration, home buying competition, and corresponding home price gains over the past several years.

We believe this reset will highlight disparities in home-price changes throughout the country in 2023. These variations are already evident in some regions, with metropolitan statistical areas (MSAs) such as Boise City, Idaho and Austin-Round Rock-Georgetown, Texas showing quarterly declines of 1.80% and 1.51%, respectively, in third-quarter 2022 (see chart 6). Depending on whether remote work becomes a permanent feature in certain industries, we believe migration back to urban areas and into multifamily housing will vary by region and persist for several years.

Chart 6