Adding/Reducing exposure to home prices in Portland and Seattle

Portland and Seattle have been in the news in the last month, with protests, demonstrations, and federal responses. Some locals have expressed concerns about the future level of home prices, and are probably uncertain what to do with the large (and binary) decision of "do I stay or do I go". Others cite the appeal of living in these iconic Northwestern cities, particularly Millennials that will drive home purchases on the margin. There have not been many pure plays to hedge exposure (long or short) to home prices in cities not referenced by CME Case Shiller home price index futures, and while macro hedges may have offered a reasonably correlated hedge in the past (see graphs below), the challenges that these Northwest cities are facing (especially over the next year) may be unique (and therefore less correlated to national indices).

OTC Home Price Hedging Fund ( agreements may be one way to add/reduce regional home price exposure to these two cities (and 30+ others). A key feature of these agreements (and CME futures) is that they allow users to customize the amount of risk that they are looking to hedge, while postponing the buy/sell decision to a later date. As I've noted before (see May 17th blog on bite-sized pieces), rather than confront the 100% Rent vs 100% Own vs 100% Sell decisions that most home-buying/selling decisions involve, one can buy/sell agreements in as small a percentage of the home value as one chooses. For example, an agreement can be structured with notional value of $100 * index value, or about $24,000.^1

(Note that I don't have any views on the future level of prices in either city, or the politics of the situation, that would influence decisions here. What I believe is that there are some who have negative views on the future prices in these cities, while others may be looking to add exposure. HPHF is just a platform that allows those with opposing outlooks to take offsetting positions with a neutral third party. That said, I'm open to taking either side of a smaller agreement to get the ball rolling on the agreements, and to promote price discovery).

These agreements take two forms: Relative Performance Agreements ("RP") and Absolute Price Agreements ("AP")

RP Agreements work well for those looking to express a view on the relative move in home prices between two indices, without having to make an explicit absolute price call. RP's involve the parties expressing a view on the ratio of a future year-end POX (Portland) index, relative to the HCI (10-city) index. For example, if today the Case Shiller POX index =245.86, and the HCI 10-city index is 236.58, the ratio of the regional index to the 10-city index is ~1.04. Thus if both index levels rise, or fall 5% by 2022, the ratio of index values will be unchanged. ^2

While the POX/HCI ratio has been very stable the last few years^3, the parties will need to negotiate the clearing level for the future level to anchor an RP agreement. Risk might clear above or below the current ratio. For example, I'd "quote" (offer to enter into an RP Agreement) on POX for Feb '21 settlement (so referencing the Dec 2020 index) at +2.00%/ +4.00% vs the Dec 2019 ratio of indices. That is, I'd propose Agreements where I'd buy at levels where the POX/HCI ratio is 2% above the Dec '19 level, and would sell an Agreement where the ratio is 4% above the Dec '19 level. For Seattle, the levels would be +2.5%/4.5%. Payouts on RP agreements are then a simple function of how far the ratio at settlement differs from the negotiated level.^4

While RP Agreements are based on relative price moves, they can be converted into views on absolute price moves by buying/selling the equivalent notional amount of HCI Case Shiller futures (that are traded on the CME). As such, if one thought that POX was going to fall, one way to express the view would be to enter an RP agreement (Short the ratio of POX/HCI, so short POX relative to long HCI) and then sell the HCI exposure in the futures market, eliminating the HCI risk.^5,^6

Finally, one could structure an Absolute Price Agreement on the POX index. While I'm open to these it seems that the RP+Futures package described above is a more efficient use of capital, and it allows the (reasonably correlated) price risk of POX v HCI to be expressed in more liquid futures. That said, I'm open to structuring smaller AP Agreements on POX , if the user doesn't have a futures account.

Please read the HPHF marketing material if you have questions, and please review disclosure language.

I'd note that these types of agreements can, conceptually, be done on any Case Shiller and Freddie Mac indices. The Agreements work best (for me) for larger cities as there is less specific risk to moves (and revisions) to indices on smaller cities.

Again, I expect more questions at this point, so please consider this a first step toward understanding this approach. Please review my website for details, or feel free to contact me if you have any questions, or if you have an index you'd like to discuss.

Thanks, John

^1 Note that there exists basis risk between the value of one house and the regional index, and that an individual home may exhibit a higher beta (sensitivity to change in regional price moves). As such, users will need to determine for themselves how these factors might influence any hedging decisions against the purchase or sale of an individual home

^2 POX and SEX here is the symbols for the Portland and Seattle Case Shiller indices.

^3 HPHF Agreements reference the year-end index values that (for Case Shiller) are released on the last Tuesday in February (two months later).

^4 Some of the variation in the ratio of the two indices, during the year, may be due to differences in the degree of seasonality in each index.

^5 Note that RP agreements are structured as options to bound the potential results. See for details, and/or contact me if you have questions.

^6 There may not be 100% elimination of HCI risk as futures price moves will be unbounded while the POX/HCI RP agreement will be structured with boundaries. (e.g. +/- 10%)

^7 To trade futures one must have a futures account at an FCM. See the Resources page on my website for a list of FCMs that I'm aware of that allow retail accounts to trade CME Case Shiller futures. (I still have a $100 reward to those that can identify additional brokers).