Sunday, March 2, 2008

Your Future Housing Options, Part 3

Currently, an insurance solution for the homeowner is to buy a put option which is generally considered safer than a futures contract as they cannot lose more than they invest. With a futures contract, the purchaser could lose more than the initial investment, although the upside is also greater than with an option. The buyer fixes a strike price and an expiration date, then pays a premium. If the index ends up being higher than the strike price on the expiration date, they do not owe any money. It is like buying car insurance and never filing a claim. If they fix a strike price and the index ends up lower than the strike price, they will receive the difference.

A comparison of buying a put option to buying insurance would be the following. Suppose you own a San Francisco home worth $1 million and want to protect yourself against a steep decline one year from now. To protect a $1 million house a year from now, you would have to buy 20 put options at a total cost of $70,000 today. To recoup the $70,000 investment, the San Francisco home-price index would have to be 12 percent lower in December 2007 than in December 2006. "It would have to go down more than 12 percent to make any money off the trade," states Fritz Siebel. “Why 12 percent? Because the market is already expecting a drop of roughly 6 percent, the other 6 percent represents the premium you are paying to buy the insurance. It's high today because there is more demand for this type of insurance than there are people willing to sell it. The premium will come down as more players enter the market.”

The Chicago Exchange is hoping that the housing contracts will catch on first with companies that need to hedge against the risk of falling real estate prices, such as homebuilders and mortgage lenders. Some of the issues preventing this are the lack of liquidity for these companies that have suffered immense losses and the cost of trades. Some insurers are also not sure of the reliability of the indexes to measure the fluctuation of home prices. Another problematic issue is the time frame of the contracts with many developers interested in long-term contracts of two to six years. The longest contract currently offered expires in one year. In addition to attracting companies from industries that have the most to lose, in order for the market to work, it will have to attract a large number of speculators, people who have no underlying risk to hedge, but who want to gamble on housing prices.

Since December 7th 2007, only 1,041 futures contracts and approximately 1,000 options contracts are outstanding. Together, those contracts insure about $100 million worth of U.S. housing. However, investors contributed only a small fraction of this amount, less than $10 million, due to the fact that investors generally buy futures and options on margin, similar to the way home buyers put down a fraction of the home's value and borrow the rest.

Although the individual homeowner could stand to benefit by investing in these futures, they do not necessarily offer a direct hedge against the price of an individual's home. Because contracts are offered in only 10 geographic regions and home prices within those 10 regions will most likely change in varying degrees, an individual could potentially see the value of his investment fall with the value of his house. Siebel feels that individuals can benefit from the investments; however, "futures markets are professional markets" and an individual should "fully understand what they're getting themselves into."

Waiting for the real estate market to rebound will be a long wait, an estimated 4 to 5 years. However, an investor still can make money in this market. With housing costs dropping at record rates, a wise investor can find properties to purchase far below market value to keep as rentals until the market stabilizes. Research of foreclosure filings, particularly tax sales, can also reveal properties with enough equity to make them good investments for a quick flip or to hold for more long term gains. With an influx of repossessed housing and properties that are heavily over mortgaged, lenders are often willing to negotiate short sales, or reduced mortgage payoffs, to avoid costly legal proceedings and repossession of properties that they do not want.

However, for a select few with discretionary income and an understanding of the derivatives markets, the Chicago Mercantile Exchange introduced housing futures and option contracts hold immense potential. These derivative instruments take advantage of declining house prices by allowing investors to purchase futures contracts, essentially betting that the values will go down, in a market almost certain to continue its historic decline. Utilizing the price-to-rent metric discussed, the current P/R ratio is at 24, 60% above the historical average of 15. Most economists agree that it will take approximately 5yrs for the P/R ratio to return to this historical average and that the foreclosure numbers have only begun to surface. Futures contracts or options as a form of home equity insurance to hedge against and/or profit from the prospective decline in housing prices are a creative and potentially lucrative option for an investor in this roller coaster economy.