****The original version was edited Saturday morning Nov 27 to move some diagrams to footnotes, and to add additional comments (e.g. notional value implied by Agreements)****
There's been a lot of research showing that people are moving from California to Texas^1. Much more affordable housing is one possible reason. ^2 However, other than relocating the family across time zones, there's been few ways to express a view on this trend, to forecast how big the impact will be on prices in the two regions, and/or to hedge if readers might be contemplating making this move. This blog will illustrate one way to try and hedge the risk of selling in one market, while buying in another (hotter market) and will hopefully, help frame the debate of "yes Texas home prices might outperform those in California, but by how much?".
Home prices in Texas have only recently begun to see the relative impact of this in-migration. The graph below shows (in black) the ratio of the Case Shiller Dallas (DAX) index divided by the Case Shiller Los Angeles (LAX ) index by index release date, over the last ~eight years. ^3 That is, the relatively flat ratio from 2016 to 2021 covered a period where both indices moved up (or hypothetically down) by similar percentages. However, during 2021, the DAX/LAX ratio has begun to rise, consistent with DAX outperforming LAX^4. The spot ratio (based on the October release) is 0.692 (250.20/361.54) higher than the 0.640-0.660 range that had prevailed.
Home Price Hedging Fund ("HPHF") Ratio Agreements^5 can be structured to allow users to express views on what the level of the DAX/LAX ratio will be at the month-end release in Feb. 2023, or to try and hedge against DAX out-performing LAX, by more than is already priced in. I've posted levels at ratios 0.72 (my bid side) vs 0.74 (my offered side)^6 to prompt debate on where the ratio is headed. The quotes I've posted are consistent with DAX outperforming LAX by ~5.4% (0.73 midpoint/ 0.692 spot ratio) over the next 16 months. Those looking for bigger relative gains might be interested in the long side of ratio agreements. Those who think that home prices changes in LAX will mirror those in DAX, might take a bearish view. Net, I'm willing to back up my view that Dallas prices will outperform those in Los Angeles by a large amount between now and expiration. ^6
Recall (review the information on my homepage) that HPHF Agreements are structured as out-of-the-money puts and calls to cap payments, and to collateralize exposures. That is, if the value of an .01 is negotiated to be $1,000, a call buyer would pay 0.10 (the 0.74 offered quote minus the 0.64 floor, or $10,000).^7 The call buyer would earn the maximum payout if the ratio got to, or exceeded the cap. The payout would be the difference between the floor (0.64) and the cap (0.82) or $18,000.^8
Similarly, someone thinking that the ratio might fall, could buy the put for 0.10 (the cap of 0.82 minus the 0.72 implied bid) for $10,000, with an $18,000 payout should the ratio at expiration be <= 0.64.
Scaling the amount of a Ratio Agreement one might consider is a function of the value per .01. For example, if the value of an 0.01 is $1,000, a move of .01 would be a 1.37% change in the ratio (0.74/0.73) consistent with the underlying notional amount of about about $73,000. That is, a 1.37% change in the $73,000 would also be about $1,000. Those looking to hedge more or less could agree to larger/smaller values per 0.01.
At expiration, Agreements will be auto-exercised with payouts to calls and puts based on the ratio at expiration.
Those looking for pure bullish (or bearish) plays on DAX might consider entering this kind of HPFH Ratio Agreement in combination with an offsetting position (of similar notional amount) in the CME LAX Feb '23 futures. That is someone with long exposure to the DAX/LAX ratio is in effect long DAX/short LAX exposure. Buying back an equal amount of the LAX notional exposure in the futures markets would offset the short LAX exposure in the ratio (over a range of outcomes) leaving the user long DAX. ^9 (For those looking to place outright view on LAX, or San Francisco (SFR) or San Diego (SDG) there are CME Case Shiller futures where one can more efficiently express such views.)
While there is no market for Ratio Agreements, I hope to develop interest on both sides to foster re-trading opportunities. In the meantime, I am open to budgeting a modest amount of capital to start the effort (from either the long or short side). Additionally, if this idea appeals to you, but the levels are away from where you'd like to take an exposure, please contact me, and I will try to build an order book. (That is, the levels I quoted -0.72/0.74 - are my sense of where there might be equal buy and sell interest. I make no claims to forecasting precise levels- but do recognize the desire by people to hedge. If there are more buyers or sellers, I will adjust my sense of clearing levels. Having an order from you in hand, with completed disclosure documents, would help to improve liquidity, and would be much appreciated.)
Please feel free to contact me if you have any questions about this blog, if you have any interest in this Ratio Agreement (at any levels), have ideas for other Agreements, or just want to learn more about the use of home price index derivatives in hedging strategies.
Thanks, John
Footnotes:
^1 For example, The New York Times had a recent feature on why everyone's moving to Texas. In addition, I stumbled across one Facebook page dedicated to the topic. In addition, Aaron Polk (of Tx Mortgage Lenders) posted a nice piece on LinkedIn showing where all the new Texans came from in 2020 (to include this map).
^2 @NikhaarShah from Home.LLC (posted this graph in June) showing the differences in affordability.
^3 Both indices are the NSA (non-seasonally adjusted) versions, consistent with CME futures. Recall that the February release date measures activity through December. February releases are highlighted in red dots to give YOY results, minimizing seasonal factors. I'm using DAX and LAX as there are Case Shiller index values for each of these tow large cities. I'm open to other cities but would prefer to focus the Texas vs. California debate to not fragment interest . (An alternative using the State of California vs. the State of Texas, or other cities vs the US is possible. DM if interested).
^4 I cite Case Shiller indices as there are public futures markets that reference the index. I'm open to writing HPHF Ratio Agreements on other public indices (e.g. Freddie Mac Home Price Indices) for cities that don't have a public Case Shiller index. Note, I agree that all indices have their challenges, but IMHO a comparison between like indices should reduce index outlier features. Further, while most indices are backward-looking, a value of this exercise is that the Agreement is on the results of a data for more than a year forward. No one has current knowledge of what these numbers can be, so it that sense the ratios are more arbitrage/data-mining free.
^5 See my website for more details on HPHF Agreements and for disclosure forms that need to be approved before any Agreement. That is, HPHF Agreements will only be done with approved counterparties who satisfy KYC, AML provisions and who either have experience in financial derivatives or who can
^6 Today prices. Agreement levels can change for a variety of reasons.
^7 In this example, I would buy the opposing put from HPHF.
^8 Wider boundaries are possible, but require higher premiums (and allocation of capital) to collateralize the bigger possible range of payouts. I strive to balance the higher premium/wider boundaries tradeoff by picking floors and caps that seem to be wide enough for the horizon of the Agreement. Longer expirations are possible but given the additional time-to-expiration, the range of final ratios could be wider, requiring wider boundaries. Similarly the range of floor to cap on different cities would be impacted by the correlation of between the two regions (often one region vs a national index) and the inputs from those looking to enter Agreements.
^9 Note that should the ratio move beyond the boundaries (floor and cap) this offsetting feature breaks down. Wider boundaries (or, at best, unlimited floors and caps) from a well-capitalized entity, would reduce this risk.