I sent this letter to participants in the Real Estate Derivative Summit being held in Zurich this week. While that was a conference focused on commercial real estate derivatives, and primarily focused on Europe, my sense was that there might be overlap between their goals and some of the work I’m trying to foster in US residential derivatives. I hope that it prompts some ideas for further product development in home-price hedging products.
BTW -If anyone knows of a conference, or organization that is more focused on the use of home price derivatives, please let me know, as I’m happy to present. I’ve given home price hedging presentations at a couple of universities, and would be eager to do so again, or for an industry group.
As always, if you’d care to discuss this blog, or any aspect of hedging home prices further, please feel free to contact me (firstname.lastname@example.org).
Toward better balance in housing derivative contracts?
A critical issue impacting liquidity, and/or clearing levels, in the CME S&P Case Shiller home price index contracts, (or I’d imagine any other real-estate derivative contract), is the relative dearth of inquiries from buyers of longer-dated contracts. Front- contracts (i.e. those expiring within 6 months) get good attention from both buyers and sellers, as traders seem to have strong (and sometimes, opposing) views about short-term index projections. Bid/ask spreads tend to be much tighter on shorter expirations (given less time for unexpected risks to pop up). In addition, as contracts cash-settle, there may be no need to unwind. I get many inquiries for hedgers (to include builders) exploring sales of Intermediate (1-2 year expirations) and even longer-dated contracts (> 2 years), but very few “buy” inquiries beyond 1-2 years.
As such, I’ve observed that implied forward HPAs, based on mid-market levels for longer-dated contracts, tend to fall below many forecasts and survey results. (More on why this may be the case in a future blog.)
There may be several reasons for this pricing, and in the end, possibly some opportunities for new products.
Key support for long-dated bids should come from natural longs, but many question “who might be the natural longs for this contract”. I would submit that answering this question, and creating products that appeal to this audience, may be the keys to building volume in housing (and other real estate) derivatives. One can tweak derivative contracts with contract nits, but enticing natural longs to participate is the key to growing this market.
(The one technical issue that has dissuaded some longs, is that CME futures settle on the index at some future date. Thus, if as today, and as seen in the SFR diagram, forward prices are higher than spot, one can’t buy futures-at today’s spot levels -because “the market” expects index levels to rise in the future. For the last five years, forward prices already have some rise priced in to them. Instead, to profit, a buyer must see a settlement price above their entry point (so a gain versus today’s “expectations”).
While the natural shorts, which are anyone negatively impacted by a decline in home prices (e.g. home owners, banks, RMBS deals, MI companies) see futures and options (and OTC products) as a hedge, the natural longs (which I’d describe as anyone negatively impacted should home prices rise) are not the entities one typically associates with futures contracts.
For example, much has been made about the Millennials delaying their transition from renters to home-owners, all while seeing home prices get away from them in the hot cities of San Fran, Seattle and Boston. As seen in the above chart (to the left), a buyer (in Dec 2016) of the Nov ’18 contract in the SFR contracts would have seen gains on those contracts, somewhat offsetting the rise in their dream house. Note, however, that some contracts (e.g. CHI, not shown) saw prices fall.
For other areas (e.g. Seattle) where there is no CME contract) one would need enter an OTC contract.
However, hedging life’s risks with futures contracts is not something that one associates with 25-year old’s. A home-savings plan product (combining savings + a proven purchase of futures, forward or options) might prove to be a more attractive package.
Another natural long for US home price exposure might be foreigners who don’t own property in the US. While much as been written of the US market as a shelter for the wealthy looking to shelter capital (e.g. investors from China, Russia and Latin America), those parties may be looking to shield capital, and/or diversify. Home price appreciation may be a (distant) secondary consideration. In addition, futures (or forward) contracts don’t require much capital, and futures brokers need to KYC and report activity to regulatory bodies both of which may be at odds with some large residential purchases.
However, there’s a growing world of middle-income investors around the world, who can’t buy entire floors in a Vancouver condo, or scoop up properties in Beverly Hills or Greenwich, who might want some exposure to US home prices (or other “hard” assets, particularly if they believe that nominal real estate price might provide some protection against easy money policies). For example, if nominal home prices move (somewhat) with inflation, an ETF backed by forward home price contracts, might allow such investors to gain access to a broad exposure to unanticipated gains in US property prices. With the dollar down, and US home prices lagging those of other countries, an index of dollar-denominated, US home prices in an ETF format might be attractive.
Furthermore, pension accounts now regularly allocate ~5% of their funds to real estate, but with a primary focus on income, and often with 90+% of their allocation to Commercial Real Estate. However, CRE is probably much more sensitive to interest rates (via CAP valuations) than US home prices, so a shift from CRE to residential might be prudent should an investor be worried about rising rates, while wanting to maintain exposure to real estate.
Also, using futures contracts might be a way for a portfolio manager to quickly ramp up an exposure to an index portfolio, and then reallocate over time as they see opportunities to add value. Similarly, a PM might be able to “park” exposure in 2-3 year futures – thereby keeping their fund allocation to a certain real estate threshold – while dramatically cutting their credit spread duration. (i.e. the volatility of a home price futures contract should be lower than that of a 20-year office lease.)
While a common lament is that futures don’t provide the income that pension accounts seek, combining put-writing strategies with Credit-linked notes might be a tool worth exploring. My sense is that hedgers are more open to buying puts than OTC forwards, so this might a source of even more-motivated supply.
I’d highlight the great success that the GSE’s have had over the last five years in writing credit-protection against the first 1-3% of the loans they’ve guaranteed. One of the key lesson from the financial crises is that loan losses are correlated with home prices. As such, a credit linked note that converts put home price put premiums into coupon payments might appeal to the same audience.
In addition, unlike the STACER/CAS programs where different issues are diversified by borrower, but all have about the same geographic exposure, an investor in CLN’s backed by home-index puts could customize their exposure, and/or diversify across the world’s cities.
Net, if you agree that the challenge is in enticing buyer interest to housing derivatives, then repacking the buy side of futures (or the writing side of puts) needs to be a primary focus. Creative applications of long positions, rather than getting clients to buy outright futures (or options or OTC forwards), is where the solution to better liquidity in housing derivatives lies.
John H Dolan
Oct 9, 2017
 Note longer-dated contracts were quoted below spot during 2007-09. See “Observations on the CME Home Price Futures Market: Were These Futures Able to Predict the Home Price Crash?” (Dolan, Hume -2010)
 SFRX18 closed at 238.4 on Dec 31, 2016. Close for Oct 6, 2017 was 254.2, or 15.6 points. Each contract has value of $250 * index level, so a contract at price of 250 has notional value of $62,500. Gain of 15.6 points or $3,900 per contract/ on ten contracts (equal to $625k) would be $39,000 in gains on futures.
 In addition, given how far forward futures settle (e.g. a new Nov ’22 contract will be introduced next month) there may be little need to continuing roll near-settlement contracts.