With the housing market nearing the important spring buying season, housing costs are in the spotlight.
economists Doug Duncan and Mark Palim think that theme will dominate the real estate conversation this year.
“The things that are the challenge for households today are interest rates and house prices,” Duncan said in a recent conversation with Barron’s. The economists are members of Fannie Mae’s Economic and Strategic Research Group, which publishes housing market sentiment indicators and a forecast each month. The theme of this year’s January forecast is, fittingly, “awaiting improvement in affordability,” Duncan says.
The two discussed how far prices could fall, where mortgage rates are headed, and what happens when the Federal Reserve exits its mortgage-backed securities portfolio. A condensed and edited version of the conversation follows.
Doug and Mark, thank you for joining us. How is this coming year going to look different than it did earlier during the pandemic?
Doug Duncan, Fannie Mae chief economist: The underlying economic factors will have a lot to do with whether affordability is achieved toward the end of the year. If it’s a recession, is it in fact a mild recession? Or do we have a soft landing?
We do see house prices coming down, but not as far as some see. We see interest rates coming down later in the year. They’ve already come down some. We think they’ll come down some more. So there would be some improvements in affordability.
Mark Palim, Fannie Mae deputy chief economist: Once we opened up a little bit from the pandemic, it was really a seller’s market. You had multiple offers on homes, people bidding on six, seven, eight homes before they finally got one. If you look at the months of sale supply, it got below two. It’s now moved back up to the high threes, so that is an indication that the market is a little bit more balanced. The lock-in effect might mean that when you go out shopping, you’re not going to have as many listings as you might like, but you’ll probably have fewer people online with you about to bid for that house.
Duncan: And because we still haven’t solved the overall supply problem, house prices will not come down as far as you think.
You said you expect prices to fall about 10% from their peak in mid-2022 to their trough in mid-2024. What are some markets where prices may fall the most?
Duncan: The markets which are seeing the largest declines are the ones that saw the most rapid run-ups. Boise and Phoenix are the standard ones that people have been talking about. In the tech space, you’ll see San Jose, and places like that, seeing price reversals as well. It’s two things: One was whether the market was kind of ahead of itself—which would be the Boise and Phoenix story—then it would be employment, which is always impactful.
Palim: The other factor was when mortgage rates went up to 7%. I mean, that’s quite a shock. Sellers have an idea of what they think their house is worth based on what their neighbors sell for. But the buyer is constrained—they have to qualify—so they immediately feel the impact. The sellers—it takes a little while for them to adjust. Just like it’s not going to be uniform across geographies, it’s not going to be uniform through time.
Mortgage rates have been a pivotal topic in the housing conversation. Where do you see them headed from here?
Duncan: One reason mortgage rates have come down is nobody believed that a mortgage-backed security backed by 7% mortgages was going to last. Because investors wouldn’t invest in that security, lenders were requiring borrowers to bring money to the table to buy down the interest rate so that it could go into a security that would be issued with prepayments fees that were acceptable to investors. That’s one thing that’s been a lever to push rates down.
Palim: The other thing is, a 6% mortgage is not that unreasonable if you take out the pandemic period. A sub- 3% mortgage means pretty bad things are happening in the economy.
What can we learn from the latest new home sales release?
Duncan: The inventories of completed homes are up significantly, so that suggests that the builders are working through backlogs. They’ve got product to sell, it’s not selling as fast. You can see that buildup start in the middle of the year when the rate shock finally hit people. That has had an impact on their sales. We would expect to see discounting start to rise.
Without significant existing supply, if our view of the recession is accurate, or even if there was a soft landing, you may not see a lot more deterioration in new home sales, because the builders still have backlog to work through. They have room to discount and still have decent profit margins.
We know the Fed is going to roll mortgage-backed securities off their balance sheet. What happens next? And what does that mean?
Duncan: We have some unanswered questions that we’re going to research. There are two or three questions. If you look at the long history, the thrift industry was the holder of mortgage debt. When they were disintermediated by the inflation of the ‘70s, and they went out of business, that actually migrated into the portfolios of the GSEs [government-sponsored enterprises], Fannie and Freddie. Then the Great Financial Crisis and the problems that the GSEs had, by regulation and law, their portfolios are constrained now to a particular low size. That migrated to the Fed. It wasn’t a policy decision to send it to the Fed, but the Fed was there, and for their real monetary policy purposes they became the largest single holder of mortgage backed securities in the world.
They now have, as a formal policy statement, that they would like to exit that portfolio. And they are running it off, but the very low interest rates that people took mortgages at are way below current market rates, so it’s running off pretty slowly. But they eventually will have to be out of that business.
Who picks it up is the question. Who’s next? You get these general statements saying that private investors will have to pick it up. OK, maybe. It’s not going to be commercial banks, because commercial banks have a very long history of a very narrow band of holding of mortgage assets. Given that long historical data, it’s hard to see there would be behavioral changes that would alter that.
So if it is private investors, at what rate? What spreads? And how would that affect volatility in that space? We don’t really have a lot of evidence or information, at least we haven’t really started a formal investigation of this yet.
What stories are happening right now that aren’t getting the attention they should?
Duncan: What’s the size of houses that are being built? Sometimes that gives you an indication of who the builders target as the buyer. The fact that average house size is coming back down is recognition by the builders that they’ve got to build to entry-level people.
Palim: One of the implications of that is we think the next recovery [in] new home sales will be a greater share of the market than existing home sales. The housing market was supposed to go into recession, but we think it will also help pull the economy out once, in 2024 in our forecast.
Thank you, Doug and Mark.
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