Impact of “neutering” of mortgage deduction on home prices. A trading opportunity?

The Wall Street Journal had an article Tuesday morning (see link) titled “Mortgage Break Faces Irrelevancy” which outlined possible impacts from proposed tax changes.  The author (Laura Kusisto) quoted several sources each of whom suggested that, under the current proposal, fewer taxpayers would be able to take advantage of the mortgage interest deduction, as they would find defaulting to use of the standard deduction (which might double) more attractive.   (See WSJ illustration below graphically depicting projected changes in use of standard deduction across selected regions.)   Based on that premise (and assuming that deduction of state and local taxes were also abolished), some (not-so-disinterested) parties, such as the National Association of Realtors (NAR), arrived at a forecast that, were the tax changes to be implemented, home prices would fall ~10%.  (See the report the NAR commissioned from PriceWaterhouseCoopers here. )

When people make such outlier forecasts (most housing experts are projecting 4-6% gains in 2018) I like to remind them that the CME Case Shiller futures and options platform provide the best public, pure-play to financially express their views.

To recap the opopportunities for housing bears, or just for those who worry about increased volatility as the tax legislation gets debated, recall that:

  • There are futures contracts on the Case Shiller 10-city index, and ten more for each of the regional components.  Six of the cities highlighted in the WSJ article have CME regional contracts.  (Note 1 –  regional definitions may not overlap. Note 2- transactions referencing other regions could be done in over-the-counter trades.) As such one can view forward prices, or take a position on an index that spans many regions, or, alternatively, if you believe that the high-priced coastal areas (that typically have higher mortgage balances and local real estate taxes) will be hit harder, trade the BOS (Boston), NYM (New York), SFR (San Fran) contracts.
  • There are 11 expirations for each contract to include quarterly contracts that mature in Nov ’18, Feb ’19 and Mar ’19.  Since the contracts cash-settle (much like the S&P 500), contract prices should eventually converge to the index value at settlement.  As such, some argue that, forward prices may incorporate some expectations of forward index levels.
  • The current CUS (10-city index) is 215.50, while the Nov ’18 is quoted 224.0/225.0 (or 3.9/4.4% above spot).  That is, the market is priced for ~4% gains, so if you believe that home prices will fall (conditional on some events) you might expect to see a sharp price decline.  This contract might be a way to express that, or just observe market reactions as proposed tax legislation moves forward.
  • In addition to futures, puts (and calls) can be traded on the CME platform.  Strikes are quoted at 5-point intervals so one might look at the 215, 220, or 225 strikes.  These are options on the futures so while they can be traded, they can only be exercised at expiration (European style).
  • Finally, if a trader thinks volatility will jump higher (or stay low), one can pursue many universal volatility strategies (e.g. buying/selling straddles, strangles, across strike combinations).

Please feel free to contact me (johnhdolan@homepricefutures.com) if you have any questions about this blog, or on the topic of hedging home price risk, or would like to discuss a trade.

Thanks,

John

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