Home Prices in the Pacific Northwest – a review of OTC trading

I noticed at least three articles in the last few days on the value of home prices in the Northeast.  Fitch issued their Q2 Sustainable Home Price report and referred to prices in Seattle and Portland as “overvalued”.    Vancouver’s Globe and Mail noted that recent taxes imposed on new foreign home buyers in Vancouver were causing investors to shift their focus to Seattle and Toronto.  Finally, Core Logic threw a monkey wrench into valuation issues with their new blog post highlighting the risk of earthquake in the Pacific Northwest.  ( I encourage readers to review all three).

What is someone exposed to such forces supposed to van-graphsdo to either figure out where home prices are headed, or how might they hedge?  What can someone do if they want to hedge exposure to either Seattle or Vancouver (or take on additional exposure synthetically) without selling the house, uprooting the family, and moving into a rental unit?

Unfortunately, there are no exchange-traded contracts for the Seattle home prices, nor are there Canadian contracts which might provide color on price expectations.  One could observe a strong correlation between Seattle and other markets (most notably Boston, since 2010) but correlations often work well right up until they don’t, and I imagine that the twin wildcards of Chinese buying and earthquake risk are not as big a part of BOS valuation.

One can trade regional bank stocks and building companies, but those don’t represent a pure play on home prices.

However, it should be possible to put together an OTC (over-the-counter) trade between interested parties (in either US$ or CAD$). I’d like to discuss the challenges in doing so here, somewhat based on my experience in putting together a similar OTC trade.

There are many differences between an OTC trade and an exchange-traded futures contract.  In an OTC trade, pricing of forward contracts may not exist (or be transparent), contracts need documentation (that may vary from trade to trade), the exposures may not be fungible and therefore may not be assignable, and most importantly, counterparty risk (i.e. the ability and willingness of your trading partner to perform) becomes a big problem.  (BTW – These are all advantages to exchange-traded, and/or exchange-cleared, products).

However, under the right circumstances, many of these issues might be addressed.  What seems to work best is a put/option trade (so one side -the put buyer -knows their maximum out-of-pocket), with coverage for a short term (which both reduces the premium and the risk to the put writer), for an uncomfortable (but not disastrous) market move.  On this last point, in my experience, short-term put writers don’t want to back into taking exposure to 9.0+ earthquake risk (particularly all along the West Coast).   In addition, the capital charges that might be assumed for such tail risk are probably high, but an out-of-the money, short-expiration put, will not generate much premium.  In addition, the occurrence of such an outlier event  will probably undermine the put writer’s ability to perform.

As such an LAX put combination could be struck (and traded electronically) but having the put buyer buy a 230 strike, while simultaneously selling a 200 strike.  This puts 30 “points” (using Case Shiller index values) at risk for the maximum payout by the put writer. (Payouts for events such as LAX dropping below 200 are best left to the Government).

The key challenge (for a buy and hold put buyer who is comfortable on price levels) is how to ensure that the put writer performs should the index value fall below the strike. (BTW -recall that all CME options are European style so the option can only be exercised at maturity.  This is a feature that I embrace when talking about puts that can be structured as forward price can theoretically be hedged, but not a spot, non-seasonally adjusted index).  In addition, a single expiration option addresses much of any seasonality issues that are relevant to home price analysis.

I’ve talked with a number of escrow companies that are happy to hold and eventually distribute collateral (should the put writer be willing to post the amount in advance) but none have wanted the liability they associate with calculating the put pay-out.  (Ideas?)  I’ve also reviewed a number of bitcoin-style platforms, but most of the ones I’ve seen pay all or nothing to one party.  For example, one could propose a market where traders could bet on whether a Seattle index (and I’m using the Case Shiller version in my graphs) was above or below some value for some specific date next year.  However, such a 0/1 payout doesn’t seem to hedge risk.

One arrangement from the blockchain mindset (that might supplement some initial collateral) is to publish the trade to a community of peers to put the put writer’s credibility at risk.  That is, if the writer promises to perform, and make payments, conditional on something happening, and he then doesn’t, then a) the put buyer has a distributed record of that failure to perform, and b) those peers will have a different impression of the put writer (and may be called to testify against the writer if litigation ensues).  This assumes that the put writer has the capacity to perform (so know your counterparty and don’t do personal trades for billions of dollars), but maybe not the willingness (AND that their reputation is important to them).

So, I think that we can get to a point where traders should be able to hedge with many issues of an OTC trade addressed.

If you’re still with me, here’s levels that I think might work for one-year puts on the Case Shiller Seattle and Canadian Teranet Vancourver indices.  Note that I show these prices to illustrate how I think a set of contracts could be written.  Net, I think that it is possible to construct a derivative for home price protection for those in Seattle and Vancouver.  If anyone is interested in fleshing this out further please get in touch.

van-puts

As always, if you’d like to discuss the themes in this blog, or any other aspect of hedging home prices, feel free to contact me (johnhdolan@homepricefutures.com)

John