« Bloomberg Speaks Out for Eminent Domain 63 Schermerhorn Update: Former Church Demo'd »

May 3, 2006

Housing Futures: Appetite for Adoption

house James Surowiecki tackles the topic of housing futures in the New Yorker this week, giving the two players in the space, HedgeStreet and the Chicago Mercantile Exchange, a nice credibility boost. Housing futures are a new derivative product that theoretically will give homeowners the ability to buy insurance against a depreciation in the value of their home and speculators a chance to play the real estate market with having to own any hard assets. We think it makes a ton of sense. So does Surowiecki, but he wonders whether there may be psychological barriers to adoption:

Even today, it’s clear that otherwise rational people harbor deep-seated beliefs that make housing futures a tough sell. People generally don’t hedge individual investments, because they don’t like to limit their potential gains in advance. That’s especially true when it comes to housing, because of the ingrained assumption that, over time, real estate is guaranteed to be an excellent investment—even though Shiller, in a recent book, shows that, allowing for inflation, American home prices barely budged during the twentieth century. In that sense, the housing-futures market has what is known as a framing problem: selling a contract seems like betting on housing prices to fall, rather than simply insuring yourself in case they do. Emphasizing that the market is a kind of home-equity insurance might help; but even that’s no guarantee.

Which of you are going to think seriously about using housing futures as a hedging tool?
Financial Page: Through the Roof [New Yorker]

Comments

While I am not an economist, I can see this tool distorting the market with speculation. Take for example the oil futures market. There is a ton of hedge fund and pension fund money pushing the curves way beyond supply and demand. Housing futures could be equally distorted, to disastrous effect to the average homeowner. Bad idea.

Posted by: Anonymous at May 3, 2006 9:48 AM

What do you mean by this?

"Take for example the oil futures market. There is a ton of hedge fund and pension fund money pushing the curves way beyond supply and demand."

Posted by: Anonymous at May 3, 2006 9:56 AM

Heheh, my DH & I talked years ago about starting our own hedge fund. Unfortunately, as he works for an IB, we can't do this. Otherwise I'd do it tomorrow & based it on Miller-Samuel or any old index.

Posted by: Anonymous at May 3, 2006 10:00 AM

The Economist points out that these instruments have settlement dates that are only up to 1 year in the future. I can't imagine that a homeowner would want to hedge over such a short time horizon unless they about to sell.

Smoothing year to year volatility has no real benefit for a homeowner who plans to remain in their home for several years.

Posted by: Anonymous at May 3, 2006 10:14 AM

First of all we will need to monitor these new housing futures contract and how they trade for a good year to see how it acts/trades.

I don't think comparing it to oil futures is a good argument because quite simply housing and oil are 2 very different types of investments. Oil is much more liquid and easily tradable where housing is more illiquid and is the only asset/investment that you can actually live in. Last I checked you can't live in a gas station pump?

Also, I would think this would be a good hedge for speculative investors and NOT the average homeowner. Speculators who have most of their assets in real estate would be wise to hedge their bet by buying puts or writing calls to cover their butts in the event of housing cooldown that last for years to come.

I worry that the average investor that truly does not understand options trading will get involved with this and lose money. All I can say is try to get the time value in your favor buy writing calls or selling puts; rather than the other side of the coin where over time the contract is worth less money.

Posted by: UrbanDigs at May 3, 2006 10:30 AM

Re: 9:56. It used to be that the primary market for oil futures would be people who needed to buy and use oil, and would purchase futures contracts. Now there are speculative investors betting that the price of oil will go up. If enough of this speculative cash chases the finite number of contracts, then the price rises based on speculative demand, not market demand.
In housing, it seems a similar scenario could take place. If the hedge fund universe goes sour on housing, it seems the sheer volume of negative short selling on these futures could distort pricing. I am not a professional investor, so perhaps I am being too simple here. But it seems there is potential for manipulation. Think Enron and energy futures.

Posted by: Anonymous at May 3, 2006 11:03 AM

whatever index they use could be a) inaccurate/manipulated b) not reflective of your specific situation. If you're in the market for a 2-bedroom in Brooklyn Heights it doesn't matter what happens to townhouses and studios in Manhattan.

With oil futures, you can always just take delivery of the oil. And the industry players are active market participants and will step in if it's mispriced. Not clear how good the reality check would be on a real estate future.

As far as attracting speculators...speculation? In real estate markets? who'd a thunk it?

In general the speculators even things out, ie they sell when prices are high and buy when prices are low. When there is a trend, they pile on and accelerate it. That's their function in a market economy. Makes the market get to the right price faster.

Unless you want prices set by something other than the market, leading to shortages and gas lines, get used to it.

Posted by: curmudgeonly troll at May 3, 2006 11:46 AM

I belive the oil discussion here was well reflectes in a NYTimes piece on Saturday, ie, oil has gone from being a commodity asset to a financial asset. This has already happened in the housing market to a degree in the form of mortgage backed securities that were developed by Lew Ranieri, primarily, in the 1990s. Mortgages have gone from being an asset backed by the property, and traditionally held by savings and loans and banks, to a financial asset that provides, among other things, a hedging tool for investors. I don't neccessarily think firms like hedgestreet are doing anything bad, but investors better know what they are doing.

Posted by: anon at May 3, 2006 11:56 AM

Everyone seems to think these products are evil and will be used to play the downside of the house market, ie shorting, puts, call writing etc. However, i think these products are actually a good way to play the long side of the housing market.

Finding, buying and maintaining a property takes time and money. Transaction costs like broker commissions and closing costs, eat into profits. Not to mention the illiquid nature of the housing market.

Who needs all that headache when you can just purchase a financial instrument that acheives the same goals?

Right now the New York index is at 212. 40 contracts will buy you $2.12 million of 'house'.

If prices continue to rise, your in good shape. If prices start to decrease, you can sell, hold, average down, reverse position. All the tools of a trader are at your disposal; limit orders, stop loss, trailing stops etc.

The investor who actually owns the physcial property has none of these tools available to them. They are at the mercy of the market.

Posted by: ItsAWrap at May 3, 2006 12:37 PM

I think most people who own homes are in it for the upside. I can't see them selling to hedge. I'd bet more participation will come from people who want additional upside exposure.

As has been stated before, real estate never goes down.

Posted by: JoshK at May 3, 2006 12:41 PM

I guess I'm missing how these contracts will change the actual supply of housing. As some have commented, futures with physical deliveries like treasuries and oil can have a direct effect on supply as traders buy or sell in the days leading up to the settlement date. (a few months ago PIMCO "unwittingly" cornered the market on certain treasury issues and prices rose sharply as traders bought scarce issues to settle contracts)

I don't see this same dynamic between futures markets and housing supply, although I can see secondary effects on mortgages, reits, asset-backed securities, etc.

Posted by: Anonymous at May 3, 2006 2:39 PM

Can anyone explain how the futures here actually work? If hypothetical investor Hannah purchases 10 housing futures contracts, does she get the right to take possession of 10,000 sq.ft. or some other measure of actual property?

Posted by: Anonymous at May 3, 2006 3:03 PM

I also request that someone explain these futures in more detail.. I know it is lame, but I just don't quite get it...

Posted by: Anonymous at May 3, 2006 3:09 PM

309 poster,
Assume the average price of a house is $500,000. You own a house worth $500,000 and are worried that if the price falls to $400,000, you will lose money. So, you buy a hedgelet that says if the price DOES fall to $400,000, you will collect cash from the person who bet price would not fall. If the price goes up instead, you lose the premium you paid for the contract, but that is made up for by the appreciation of the house. It can be used for speculating, but that is not the only use for futures.

Posted by: anon at May 3, 2006 3:28 PM

The CME futures are contracts to "deliver" a house price index times $250. No actual houses are delivered, but the contract is cash settled by the parties based on the value of the index at contract expiry. The index had a value of 100 in January 2000 and is currently 212 for NY Metro.

The market price of a contract is based on the consensus about the index value at a future date less the time value of tying up money in the contract. If Sept2006 futures were going for 214*250=$58750-(time value of money), for example, this would indicate that the market thinks that housing prices will rise about 1% by September of this year.

If you thought they might actually rise 5%, and you wanted to "lock in" the 1% market consensus because you plan to buy a home in September, you would buy the future contract.

At settlement you could sell the contract that predicted a 1% rise, for the index value in September times $250. If housing prices indeed rose 5% you would make enough profit on the contract to offset the extra money you had to pay for the property.

If you thought prices were going to fall, instead of buying a contract, you would sell one. That would put today's price in your pocket, but you would "deliver" on the contract by buying at a (hopefully) lower price based on a reduced future index value. You would then keep the contract price decline. If you sold the contract in anticipation of a future property sale, the sale of the contract would effectively hedge your exposure to declining prices.

The the contract that will trade on the Chicago Mercantile Exchange (CME) is based on the Case-Shiller/S&P Home Price Index. This is based on repeat sales within the market. That is, a weighted average of the price changes for home since it's last sale. The index is update once a month to reflect sales in the past month. It's complicated because every repeat sale has different holding period and an adjustment has to be made. The index must also deal with improvements/renovations and other details. By definition, the index only looks at sales of existing homes, because only existing home can be sold twice.

I hope this helps.

Posted by: bkborn at May 3, 2006 6:26 PM

Itsawrap you are very foolish to think homes do not go down. They have before and will go down again at some point.

Posted by: Anonymous at May 3, 2006 6:46 PM

6:46, i never said homes do not go down. Au Contraire. I am more bearish than anyone i know when it comes to the housing market. I firmly beleive that the rent vs own equation heavily favors renters. I would not buy properties for investment purposes at these levels because of the carrying cost, maintainance costs and the illiquid nature of RE.

That being said, these hedgelets allow someone get exposure to RE market without the extra burden of phsyical ownership. As i said i'm bearish, but not a permabear and I'm not foolish enough to fight the trend. While prices have leveled and are stagnating, i wouldnt necessarily call that a trend change. The trend is your friend.

My bearish bias would force me to place strict stop loss or trailing stop loss orders on any long trade placed. These 'tools of the trader' help mitagates much of the risk associated with 'traditional' RE investing.

The great thing about capital markets is that there is a buyer and seller in every transaction. Both sides think they're right and only time will tell who is correct.

Posted by: ItsAWrap at May 3, 2006 7:34 PM

These comments missed the possible effect of exposing distortionary tax effects. Now one can buy a home strictly for the writeoffs even if one doesn't want to be invested in the housing market – by taking out an opposing bet on the hedgelet.

This won't necessarily have an effect on the tax office, but if more and more revenue goes missing because people adopt such a strategy, maybe they will revise their stance toward renters and cut the subsidy to owners.

Posted by: crasshopper at June 6, 2007 10:03 AM

« Bloomberg Speaks Out for Eminent Domain 63 Schermerhorn Update: Former Church Demo'd »

May 3, 2006

Housing Futures: Appetite for Adoption

Comments

Post a comment

Latest Restaurant Additions