Picture a six-lane highway with roughly 110 million cars. The posted speed limit is 55 miles per hour, but there is not a police officer in sight. Since there have not been any major accidents in years, it is common practice to travel at 90 miles to 100 miles per hour, and insurance companies are lowering their premiums – often regardless of the state of the cars.
That describes the U.S. mortgage market from 2003 to 2006. The story ended exactly as you would imagine: a massive accident with severe repercussions not just for housing, but also for the financial system and the global economy.
Today, the six-lane highway has been reduced to three lanes, as origination capacity has been halved. One is a fast-pass lane for customers who have been sitting in traffic the past couple of years and are now being rewarded for good behavior with access to historically low mortgage rates: the HARP lane. (The Home Affordable Refinance Program helps homeowners refinance who are underwater or near-underwater but current on their mortgages.) But for everyone else, the speed limit has been reregulated to 35 miles per hour. There are police officers at every mile marker, and the insurance companies are charging much higher premiums.
Where do we go from here?
Despite fewer lanes on the mortgage highway, we believe the U.S. housing market has bottomed and is showing clear signs of a gradual and broadening recovery. The upward trajectory of housing prices should continue at a moderate pace. Over the past 100 years, housing has appreciated at roughly the rate of inflation. It is only in the past 10 years that housing has traded with substantial volatility due to leverage and “affordability” products. We believe the tailwinds are in place for an 8%–12% appreciation in housing over the next two years. Over the longer term, we expect a return to historical normal performance for housing relative to the rate of inflation.
We consider several dynamics in developing our outlook on housing: household formation, inventories, affordability and access to credit and lending.
We remain constructive on the state of the housing market but recognize the road is far from smooth.
On balance, we believe the positives outweigh the negatives and look for housing to appreciate 8%–12% over the next two years. Housing should have positive influences on consumer confidence and labor mobility.
In terms of investment implications, we believe both agency and non-agency markets offer opportunities to generate excess returns, while active management should be able to add value to structural allocations. Agency mortgage securities offer liquid investments that can be traded against each other as well as against other liquid interest rate markets, specified mortgage pools and, less frequently, structured mortgage products.
Non-agency mortgages continue to offer the best risk-adjusted returns in the sector, but specific security selection will matter much more given their recent high returns. Compared to investing directly in real estate, which requires time to close, lawyers, insurance and transaction costs, non-agency mortgages offer similar returns without the friction. Pairing non-agency mortgages with agency mortgage-backed securities potentially provides an attractive return profile across a wide range of economic outcomes.