With the release of Freddie Mac's home price indices for December, HPHF agreements can be settled (and quotes on Jan '22 and Jan '23 agreements can be updated).
One feature of the agreements that became very relevant was that agreements were bounded by ~+/- 10% price moves. Using Birmingham as an example, a Nov 2019 agreement struck at 161.0 (which was already a premium to spot) included a cap of 175.0. Of course the next 14 months brought us Covid, historically low mortgage rates, a flight from major 24/7 cities, and a demographic bubble that may have finally started to buy first-time homes in more affordable areas. Net, the year-end Freddie NSA index (the one used to settle this trade was 179.97. As such, the payout was settled at the cap price of 175.
While the buyer may have (in hindsight) wanted a higher cap, the role of the caps was to allow the total possible payout to be defined, and for the counterparties to fully collateralize any price moves, upfront. There may be other counterparties with more capital who are willing to take uncapped price move risks (but I haven't seen any in home prices), but negative prices on oil futures, shorts on Game Stop, and wrapping of RMBS CDS (and other issues), have demonstrated time and again, that outlier risks exist, even if your model doesn't pick them up.
Net, a long position with a cap was still better than no long position, and a short position with a cap was better than an uncapped position. Both sides did better than some alternative scenarios, and I (as a short) lived to trade another day.
Going forward, I still have a willingness to take either side of HPHF home price index agreements. (See the illustration to the right for an example of quotes on Birmingham for Jan '22 and '23. Also, see the My Quotes page for updates to pricing of HPHF OTC agreements that reference Case Shiller indices, DM me if you have an interest on other cities, and follow my on Twitter - @HomePriceFuture - for ideas on other cities).
While I'm open to taking outright positions (see HPHF page for how they would be structured), a better way (for me) to handle the risk, and to allow wider bands is in the form of Relative Performance ("RP") or Ratio trades. I reviewed RP agreements earlier this year in a July blog (and will review again soon -using Birmingham as an example).
Ratio agreements are another way of saying that City A will do better than City B (or a National Index) by structuring an agreement on where the index level of one, versus another will be in a year or two. An advantage of Ratio trades is that most cities have some correlation to the National Market and each other (the bigger, the more likely). That correlation dampens the price moves (of the ratio) allowing for a broader band of results. For instance, in the attached example, while the pricing of the Jan 2022 ratio has Birmingham doing much better than the National index, the range of outcomes is still very tight. In effect, if you want to "bet" that home prices will do well, focus on the CME Case Shiller HCI (10-city index) contracts as that's where systemic home price risk can be added/ hedged in a much more liquid, capital-friendly, fashion, and focus on RP agreements for your alpha. (I'm happy to present a combination package).
In addition, I'm open to writing puts (or calls) on index levels. More on that in a future blog, but the numbers to the right are indicative of where I'd structure agreements.
Feel free to DM me if you have any questions about this blog, have cities that you'd like to add/reduce exposure, or just want to learn more about using home price index derivatives in hedging strategies.
Thanks,
John