Tuesday, February 5, 2008

Your Future Housing Options, Part 2

Continued from Your Future Housing Options, Part 1

Homeowners and investors looking to hedge against the decline in housing prices may find respite in an old corner of the financial market that allows them to bet on changes in future prices. Futures and options, known in the financial world as derivatives, help investors offset the risk exposure of their portfolios. A futures contract is a legal agreement to buy or sell a product for a given price at a given time in the future (hence its name), typically commodities such as pork bellies or oil. An option gives the buyer the right, but not the obligation, to buy or sell a security at a given price at or within a given time. Speculators buy futures and options to try to profit from market volatility; hedgers use them to offset the risks of adverse market movements on their investments. Most futures contracts are for physical commodities such as cattle, pork bellies or coffee beans, while the housing contracts are pegged to a more complex index of housing prices. The contracts for housing are tied to the S & P/Case-Shiller Home Price Index, a survey of housing prices in 10 metro areas (Boston, Washington DC, San Francisco, Denver, Chicago, Miami, L.A., Las Vegas, New York, San Diego) developed by Shiller in conjunction with Professor Karl Case and Standard & Poor's.

In late May, the Chicago Mercantile Exchange introduced Housing Market Futures and Options, an investment vehicle similar to futures contracts that allows investors to hedge against changing commodity prices. The exchange hopes that investors will seek protection through these instruments at a time when many anticipate a prolonged real estate decline. Futures contracts traded on the Chicago Mercantile Exchange show that traders expect double-digit declines in 9 out of the 10 biggest housing markets in the U. S. with the only exception Chicago, where prices are still expected to fall by 5.6% over the next year. In the latest batch of data released by Standard & Poor's for its S&P/Case-Shiller home price indexes, the national index of home prices showed a drop of 4.5% (yr/yr) from the third quarter of 2006, and a sequential decline of 1.7%. This sequential 1.7% slide is the largest since the index was first created. Robert Shiller, chief economist at MacroMarkets, responds to this report, "There is no real positive news in today's data."

To further understand how this proven method of investment in a volatile economy can be applied to the current housing market, consider the following. Futures and options are contracts that trade on exchanges to allow investors to bet on prices going up or down. They are known as derivatives because their price movements are derived from the price movements of an underlying security, asset or index. Investors' predictions about these real estate markets are certainly not guaranteed to be accurate. They do provide, however, insights into what people with skin in the game think lies ahead. These types of "predictive markets," have proven to be surprisingly accurate in forecasting everything from the outcome of political elections to housing movements.

To apply this strategy, suppose you own an expensive house in San Francisco that you are afraid will suffer a severe decline in value, but you do not want to sell it and move. You could stay in the house and sell futures or buy put options on the San Francisco housing price index. If home prices in San Francisco fall, the value of your house will probably go down as well. However, this loss will be compensated by the money you will earn on your futures contracts. If you bet wrong, you will lose money on your contracts, but you will have essentially insured yourself against this loss and will have retained the value in your property or possibly realized an increase. Unfortunately, futures and options have a steep learning curve, too steep for the average homeowner who wants to place a one-time bet. The housing contracts are also quite costly at this time as they are still relatively new and thinly traded. While the average homeowner can participate in these publicly traded futures, the cost of hedging might prove prohibitive unless they hold prime and pricey real estate that they want to protect. Each Mercantile housing futures contract is valued at $50,000.00 with an initial buy-in (also called a good faith investment or margin) of $2,500 (five percent of the contract's value), not including brokerage fees. Contract values have not been announced for the CBOE housing futures yet, but its offerings will carry a 10 percent to 15 percent initial buy-in.

Smaller-scale investing in housing futures has been offered since May 2005 at
HedgeStreet.com, a San Mateo, Calif.-based online exchange that offers futures contracts at up to $10 each. The new Housing Price Hedgelets are tradable as both Yes/No and Variable contracts with 3-month and 6-month durations and are benchmarked against the National Association of Realtors (NAR) reported Median Sales Price of Existing Single-Family Homes in Chicago, Los Angeles, Miami, New York, San Diego and San Francisco. Hedgelets are unique financial instruments that do not exist on any other market. John Nafeh, CEO of HedgeStreet states, "For most Americans, their home is their single largest investment and, as such, the desire to reduce risks surrounding that asset is important. Housing Price Hedgelets provide a unique way for them to hedge against depreciation in the value of a home, or conversely, speculate on the degree to which housing prices will appreciate."

The concept of insuring yourself against a big drop in the value of your home, the same way you can insure against losses from fire, hurricane, or a guest who gets drunk and falls down your steps, is a comforting thought. Someday, it might be as easy as adding a rider to your homeowner's policy. Shiller predicts that "Once we have a futures market, then people can develop home equity insurance and mortgage products that protect the equity in the home and they in turn can then use the futures market to hedge the risk they assume by creating these products." The housing futures market will hopefully, in turn, provide large insurers a way to hedge the risk of offering home equity insurance to consumers.

Concluded in Your Future Housing Options, Part 3


Ogma said...

Thanks -- a very nice summary.

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