The Big Idea

The good news and bad news in housing

| June 2, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The idea that home prices would rise this year looked like an out-of-consensus call last fall, but it has slowly become mainstream. Home prices have largely shrugged off the impact of high interest rates and low affordability. But that is something Karl Case, of Case-Shiller fame, put his finger on at least 15 years ago. Home prices should continue accelerating this year and beyond, barring a sharp rise in unemployment. That is good news for a range of assets that rely on homeowner credit, but bad news for a Fed fighting inflation.

All home price indices now pointing up

The path of home prices depends on which index you watch, but all now point in the same direction—up. S&P/Case-Shiller index and the Federal Housing Finance Agency (FHFA) both publish well known repeat-sales indices for national home prices. Both have versions adjusted for the seasonal rise in prices into mid-summer and their fall into mid-winter. Last fall, nearly every index had dropped from a June peak. But from January through March, all point up (Exhibit 1). The two Case-Shiller indices show prices down less than 4% from their peak last June. The FHFA raw index shows prices down only 0.5% from their peak. And the FHFA seasonally adjusted index actually shows prices up 1.4% from their peak. All the indices arguably show prices resilient to the pressure of high interest rates and low affordability.

Exhibit 1: Indices of average US home prices since January point up

Source: Bloomberg, Santander US Capital Markets

The differences in the indices clearly reflect differences in their construction. The Case-Shiller indices cover the broadest sample of properties—ones financed with Fannie Mae and Freddie Mac loans, FHA and VA loans, larger loans that exceed government program limits and both loans used to purchase homes and loans used to refinance. The FHFA index only includes properties purchased using Fannie Mae and Freddie Mac loans. Given the greater stability in the FHFA indices, the simplest interpretation of the differences is that the market financed by Fannie Mae and Freddie Mac has been more resilient than either the FHA or VA or jumbo markets. It is also possible that the FHFA indices are more accurate since they involve only arms-length purchase transactions and exclude refinances, where property valuations depend on appraisals.

The Karl Case case: home prices are sticky downward

Karl Case anticipated this kind of market at least 15 years ago. Home prices, he noted, are sticky downward. Regular surveys of sellers show many homeowners unable to get their target price just leave the price unchanged and wait for a buyer to come along. Or take the house off the market or rent it. Some consider lowering the price step by step hoping to find a buyer. And a small minority lower the price until a buyer is found.

“Downward stickiness has been most evident when demand declines are triggered by mortgage rate increases and most homeowners are sitting on fixed-rate mortgages,” Case notes. For the current market, that should sound like déjà vu. Case sketches a classic example of California, where home prices from 1975 to 1980 rose 147%. But after mortgage rates in 1981 rose to between 16% and 18%, nominal prices that year and in the years afterwards never fell. In Vancouver, Canada, however, where home prices in the late 1970s paralleled California and interest rates also rocketed up in the early 1980s, prices in the early 1980s fell by 60%. The difference: most of the Canadian market, Case points out, was financed with adjustable-rate mortgages (ARMs).

ARMs, it turns out, prevent homeowners from simply sitting around and waiting for a buyer to show up at the homeowners targeted price. The rising cost of financing burns down the homeowner’s reserves and forces a seller to find a clearing price—either voluntarily or because a bank takes the property through foreclosure.

The striking difference between the California and Vancouver housing markets in the late 1970s and early 1980s is echoed in other episodes:

  • The rising share of US properties financed in the 2000s with subprime and Alt-A ARMs led national home prices to peak just as the Fed finished hiking into 2006 and then, for the first time in decades, began to fall; Home prices continued falling as short sales and foreclosure sales, according to the National Association of Realtors, approached half of all home sales by late 2008
  • Even in the current episode, the decline of home prices in Australia, Canada and New Zealand, all markets largely financed with ARMs, has significantly outpaced the decline in the US

After massive refinancing in 2020 and 2021 and the quick rise in rates in 2022, more than 98% of outstanding US mortgages have rates 75 bp or more below the current 30-year average mortgage rate of 6.75%. Beyond the current sticky pricing in housing, Case’s observations about homeowners also shows up in home sales. The tendency homeowners with low mortgage rates to sit on their properties arguably has led existing homes sales to remain below pre-pandemic levels while new home sales—where no owner has a mortgage to protect—rise back to pre-pandemic levels and meet continuing demand for housing (Exhibit 2).

Exhibit 2: Existing home sales run slow while new homes sales rebound

Source: Bloomberg, Santander US Capital Markets

The main risk to home prices: unemployment

Home prices do decline, of course, and beyond the impact of ARMs, unemployment poses the greatest risk. Unemployment can also burn through a homeowner’s reserves and force a homeowner to find a clearing price. Texas in the 1980s after a crash in oil prices and Southern California in the 1990s after retrenching in the defense industry are prime examples. With national unemployment now 3.5%, the broad risk is low. That is especially true for homeowners. Homeowner unemployment usually runs well below average, according to the Urban Institute, coming in at around 80% of the total unemployment rate. But unemployment does vary across housing markets, and since the peak of home prices in June 2022, changes in state unemployment rates show a broad relationship to changes in home prices (Exhibit 3):

  • The states with relatively large increases in unemployment rate tend to show relatively large declines in home prices. California, Washington and Oregon, for example, have seen their unemployment rate increase between May 2022 and March 23 by 0.4% to 0.6% and have watched home prices decline by 4% to 6%.
  • The states with relatively large decreases in unemployment rate tend to show relatively large gains in home prices. New Mexico, Wisconsin and West Virginia, for example, have seen their unemployment rate decline by 0.4% to 0.6% and watched home prices rise by 0.5% to 3.0%

Exhibit 3: Rising unemployment tends to come with falling home prices

Note: Data shows change in statewide unemployment rate and statewide HPA from 5/31/22 to 3/31/23.
Source: Bureau of Labor Statistics, Santander US Capital Markets

The clear negative correlation between changes in unemployment and changes in home prices is noisy, but other factors play a part in home price appreciation. Local per capital income, limits on available land because of zoning or other restrictions, net in- or out-migration and so on all affect home prices. But unemployment is likely to be the most important factor distinguish local housing markets in the near term.

Implications for investors and the Fed

For investors, downward sticky home prices and a tight labor market make a bullish case for a range of assets:

  • For Fannie Mae and Freddie Mac credit risk transfers
  • For credit-sensitive classes in non-QM or jumbo mortgage securitizations
  • For single-family rental securitizations
  • For the debt of new home builders

For the Fed, downward sticky home prices put drag on an important lever for reigning in inflation. Shelter has a 35% weight in CPI and has been running well above the 1.67% month-over-month pace needed to hit the Fed’s 2% annual inflation target (Exhibit 4). Much of that elevated pace reflects owners’ equivalent rent, which tends to follow home price appreciation with a substantial lag. With fixed-rate mortgage debt blunting the impact of Fed policy rates on home pricing and prices likely to rise this year, the Fed likely will have to reduce inflation in other sectors of the economy to get overall inflation back to target.

Exhibit 4: Shelter inflation has been running well above the Fed target

Source: CreditSights, Santander US Capital Markets

* * *

The view in rates

With the resolution of the debt ceiling, the market now turns to the Fed. The Fed clearly sees policy as tight, as Fed Chair Powell noted in his press conference after the May FOMC. The latest Senior Loan Officers Opinion Survey suggests tighter bank credit is helping as well. And the uncertainty around the debt ceiling showdown has also likely temporarily tightened financial conditions. OIS forward rates now have a full 25 bp hike baked in by August followed by a 25 bp cut by December.

The Treasury will now have to replenish the cash used through extraordinary measures to operate under the debt ceiling. That is estimated in the neighborhood of $1 trillion over the next few months. Many money market funds have cash in RRP and should be able to absorb the supply without too much pressure on T-bill yields.

Other key rate levels:

  • Fed RRP balances closed Friday near $2.14 trillion. Attractive levels on T-bills in the wake of the debt ceiling resolution is almost certainly drawing away RRP cash.


  • Settings on 3-month LIBOR have closed Friday at 550 bp, up 12 bp from two weeks ago. LIBOR goes away after this month. Setting on 3-month term SOFR closed Friday at 523 bp, up 7 bp from two weeks ago. The gap between LIBOR and SOFR is effectively right at the recommended ARRC spread of 26.16 bp
  • Further out the curve, the 2-year note traded Friday at 4.50%. With the Fed likely hike again and hold fed funds at higher levels into next year, fair value on the 2-year note is around current yields. The 10-year note closed at 3.69%. With inflation likely to drift down and growth likely to slow, fair value on the 10-year note is lower than current yields.
  • The Treasury yield curve traded Friday afternoon with 2s10s at -80, flatter by 21 bp over two weeks. Expect 2s10s to flatten further. The 5s30s traded Friday morning at 4 bp, 16 bp flatter over two weeks.
  • Breakeven 10-year inflation finished the week at 220 bp, down 4 bp in the last two weeks. The 10-year real rate finished the week at 151 bp, higher by 8 bp in the last two weeks.

The view in spreads

With the debt ceiling resolution, volatility has dropped off. The June 14 FOMC should lower it further. That should help nominal spreads in MBS and credit. The Bloomberg investment grade cash corporate bond index OAS closed Friday at 158 bp, tighter by 11 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 176 bp, down 20 bp in the last week although only by 4 bp in the last two weeks. Par 30-year MBS TOAS closed Thursday at 60 bp.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market are funded with floating debt. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure starting in September.

Steven Abrahams
1 (646) 776-7864

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

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