The residential mortgage and housing markets have experienced substantial volatility over the past three years. After a spike in forbearances at the onset of the pandemic in 2020, the U.S. saw unprecedented home price growth, record low mortgage rates, and strong mortgage origination volumes. All this changed in 2022 when Federal Reserve rate hikes induced a rapid increase of over 300 basis points (bps) in the 30-year fixed-rate mortgage (which as of now is close to 8%). This shock to affordability was accompanied by a sudden drop in originations, a decline in prepayment rates, and a slight contraction in homes prices at the national level in fourth-quarter 2022. Despite the volatility over the past 18 months, mortgage performance has generally held up across the various subsectors rated by S&P Global Ratings (see chart 1). Although buying a home today is a greater financial burden than it was only a few years ago (affordability is at the worst level in almost 40 years), mortgagors have displayed a consistent ability to service their home loans.

Despite a brief dip in home prices at the end of last year, attributable to the bump in mortgage rates, the correction at the national level appears to have been short-lived and nowhere near as severe as many market participants had expected. In fact, the monthly Purchase-Only Index published by the Federal Housing Financing Agency (FHFA) indicates that seasonally adjusted August price appreciation was up about half a percentage point and was roughly flat on a seasonally unadjusted basis (in August 2022 the adjusted index was down about a third of a percent and down almost a full point on an unadjusted basis). While S&P Global Ratings economists no longer view a U.S. recession as a likely outcome this year, we are expecting an economic slowdown and an increase in unemployment. Nevertheless, the supply constrained market and generally strong home equity positions suggest that both the housing and mortgage markets should remain in good shape over the next year or more, notwithstanding the softness in mortgage origination and home sales.

Chart 1

HPA: Moving 'Against the Wind'

Had one polled market participants one year ago and asked how much home prices would fall over the following 18 months, the average response might have been around 10%, with some individual estimates far more dire. The reality turned out to be quite different. With second-quarter 2023 year-over-year U.S. home price appreciation (HPA) near 3%, any correction in prices at the national level may have already taken place between third-quarter 2022 and first-quarter 2023. At the regional level, however, the magnitude of the correction varied and may be ongoing. Chart 2 illustrates the HPA (measured as a change over the past year) across roughly 400 metropolitan statistical areas (MSAs). The heat map shows that there is substantial variation in home price growth across the country, with the Eastern and Atlantic regions showing more upward momentum than the Mountain and Pacific Northwest regions.

Chart 2

Parts of the West Coast, including the San Francisco MSA, have been affected by population migration, weakness in the technology sector, and the increasing popularity of remote work. Also, rising interest rates have had a disproportionate effect on high-priced regions that are now even less affordable than prior to the pandemic. Lack of supply has long been a major factor driving home prices, and the issue has been recently exacerbated by the sudden increase in mortgage rates. Owners who locked in record-low mortgage rates a few years ago (now over 300 bps points out of the money) are now reluctant to sell--the "golden handcuffs" phenomenon. Chart 3 shows the recent decline in total home sales along with the relative decline in existing home inventory. Over the past decade, new homes have made up only about 15% of the total home inventory. This figure has recently climbed to roughly 30%, partly attributable to renewed building. However, much of the relative increase is due to reluctance on the part of existing homeowners to sell.

Chart 3

When Will Mortgage Rates 'Turn the Page'?

The relationship between mortgage rates and home prices can be complicated. In the current market, however, mortgage rates appear to be the main countervailing factor offsetting the upward force exerted by the chronic supply-demand imbalance. Movements in the 30-year fixed-rate mortgage are very closely correlated to those of the 10-year Treasury note yield. Historically, the spread between the two has been about 175 bps.

Occasionally, this spread widens dramatically. After the GFC, liquidity issues widened the spread as investors turned away from mortgage-backed bonds (and spread products broadly) in favor of Treasury bonds (in classic 'flight to quality' behavior). The current spread of the 30-year fixed rate mortgage to the 10-year Treasury note yield is roughly 300 bps--the highest level since the early 1980s (see chart 4). It appears that, unlike the post-GFC period, the current spread widening is largely a result of perceived interest rate risk in the form of convexity concerns and general uncertainty as to when the Fed might pivot from its current monetary policy trajectory.

Chart 4

S&P Global Ratings' baseline forecast is for the 30-year fixed-rate mortgage to drop to an annual average of 5.3% in 2026 and for the 10-year Treasury note yield to average 3.6% during the same year. This would bring the spread between those rates back in line with the historical norm as interest rate uncertainty and duration risk dissipate.

As an illustration of the effect such a rate reduction could have upon home prices, we allowed the mortgage rate to decline 25 bps per quarter, which, after two and a half years, brings us near our 2026 forecast of 5.3%. We determined the current monthly mortgage payment that would be required to purchase a $500,000 home and a $1,000,000 home. Assuming the monthly payments are held constant, falling rates imply that the same borrower could afford successively more expensive homes. Chart 5 shows that these implied price increases on the $500,000 and $1,000,000 homes lead to a quarterly HPA in the range of 2%-3%. The chart also shows the decrease in the periodic debt-to-income (DTI) ratio that might result if the borrower simply refinanced at the lower prevailing mortgage rate at any point in time. Irrespective of home price, refinancing after a couple of years would result in substantial deleveraging. Indeed, a borrower would be more likely to refinance than to move; however, the illustration is an indication of the possible upward pressure that might be exerted on different housing markets in a falling rate environment.

Chart 5

Existing home inventory will presumably rise as rates fall; however, rate reductions could take several years, and market participants may have to get used to the new normal. There exists a critical interest rate level at which homeowners would be willing to break free from their golden handcuffs and move. Furthermore, mortgagors who recently took out mortgages may be eager to refinance when interest rates eventually drop. These two factors should spur business for originators keen to fill their pipelines. Overall, we expect originators will be incentivized to offer low-cost refinancing to a broad borrower base given market conditions. The good news is that underwriting standards have remained generally strong with minimal 'credit creep'. This means that performance should hold up even as origination volume increases.

Is a 'Shakedown' for Mortgage Obligations in Store?

S&P Global Ratings has forecast annual unemployment rates of 3.6% in 2023, increasing to 4.1% in 2024 and eventually to 4.7% in 2025. Based on the historical relationship between performance and the labor market, this trajectory suggests that only a limited increase in delinquencies is on the horizon. Moreover, home equity (a strong performance predictor) among owners should be poised to increase as supply remains constrained and rates are expected to fall over the next two years.

While the U.S. consumer appears to be in relatively good shape in terms of the average debt service ratio and credit utilization (see "U.S. Consumers Could Rally Despite Higher Debt Burden", published Oct. 13, 2023), the resumption of student loan repayment in October (after a three-year hiatus) is potentially problematic. However, the magnitude of the typical monthly student loan payment is substantially smaller than the average monthly mortgage payment, so this should generally have minimal impact upon mortgage performance. Moreover, there are various workout options available to those with student loan debt, and we anticipate that a borrower would prioritize mortgage (and other debt) obligations above student loan debt repayment.

On the other hand, the DSCR subsector of non-QM, which depends on the relationship between rental payments and property rental yield, could be negatively affected by the resumption of student loan repayments as this additional debt burden could erode disposable income and put downward pressure on asking rents. For a population of DSCR loans collateralizing transactions we rate, the median property value was $250,000, and almost 40% of the loans were associated with property values below $200,000. This suggests that typical rental payments are considerably lower than the average mortgage payment of owner-occupied homes. Properties in the $100,000-$150,000 range had the highest representation within our population; these had an average rent of roughly $1,200.

We used this information to illustrate the shock that a renter might experience upon resumption of student loan repayments. We considered various combinations of home values (and corresponding rent payment/yield) and examined how additional monthly obligations in the form of student loan payments would impact the renter payment ratio and rental yield of the property (assuming the student loan repayment translated into a direct reduction in collected rent). For each of the property value rental yields, we started with a rental payment ratio of 25% (e.g., $1,000 per month rent and $4,000 per month income) and two hypothetical but plausible student loan repayment amounts ($300 and $500). We then examined the change in payment ratio. As expected, lower rent payments are associated with higher payment shocks as student loan payments resume (see chart 6).

Chart 6

Overall, we believe housing market fundamentals will remain stable with neither severely elevated delinquencies nor material house price declines over the next two years as interest rates eventually drift down and affordability constraints ease. There could be regional variation, however, as populations shift due to an evolving hybrid-style work environment. While the consumer may face challenges as the economy slows, most mortgagors in the U.S. hold low fixed-rate loans and will therefore continue to enjoy inflation-protected monthly housing payments (except for taxes and insurance). Moreover, strong equity positions built up over years of home price appreciation incentivize timely payments and, in turn, generally stable RMBS performance.