The basics of hedging home prices from the long side

For years, I've been blogging about how readers could use home price index derivatives (and specifically here, the CME S&P Case Shiller futures) to express bearish views.^1 To those who said, "I think home prices are in a bubble, and will be lower next year", I'd explain how they could sell futures at a premium to today's prices (the spot index) and make money even if prices were unchanged. For example, if the spot index was 100, the one-year futures price was 105, they might believe that the index was headed to 90. Since contracts "cash settle" on the index value at settlement, even if the index one-year forward was 101, the seller would make four points, or $1,000 per contract. Net, you could have been bearish, been wrong, but made money. The settlement (101) just had to be more bearish that the clearing level (105) at the time.

Note, that selling contracts at a premium to spot, was often available even during periods when the stock market was falling.

Well now the markets have flipped and the same point can be illustrated on the long side. Quotes on one-year CME Case Shiller home price index futures have collapsed in the last few days.   (See table below -from early Thursday). Mid-market values on the G21 (Feb 2021) contracts have re-priced to levels equivalent to 8-10% decline in index value for the 10-city (HCI) contract by year-end 2020, and prices that range from a decline of ~13% for CHI and LAV, to the most "optimistic" regions (BOS, DEN) where contract prices are "only" 5-8% below year-end 2019 values (the index released in Feb 2020). In the reverse of the above, home price futures are being quoted at larger discounts, even as S&P futures have rallied 100's of points from the lows.

Those who argue that "home price didn't decline in 4 of the last 5 recession" or who believe that low inventory, low mortgage rates, and a demand by Millennials will keep home prices from falling, might consider a long exposure to Case Shiller futures. For example, if someone believes that Miami home prices (defined here as the Case Shiller MIA home price index) will be unchanged (defined as the 2019 and 2020 year-end index values being the same^2), they might consider buying the Feb '21 MIA contract. Mirroring the bearing hedge, housing bulls can buy index futures at a discount. For example, if they buy at 231, and the contract settles at 247, they would make 16 points per contract, or $4,000. Net, you could be bullish, be wrong, and still make money. As above, they don' have to be "right" to make money, they just need a more bullish view than today's clearing level (e.g. 231) to be profitable. ^3

While expressing a view may be an end in itself, bearing and bullish hedges may sometimes also be useful in hedging a user's exposures. Just as a bear hedge might be worth considering for someone who felt they had too much exposure to home prices, a bull hedge might be worth exploring for someone under-weighted to home price exposure. Examples might include renters looking to eventually buy, owners looking to up-size (e.g. move into a bigger house as the family expands), or, at an institutional level, entities that believe that exposure to home prices might be correlated with the liabilities they manage. In effect, home price index values are ~10% lower than where contracts were two months. For someone who was going to buy "someday", current index values might present a relatively attractive entry point.

Also, similar to how people have used bear hedges, someone considering a bull hedge doesn't have to make the binary "I'm all in" decision. CME contracts have notional values of $250 * Price, so a contract trading at 200 has about a $50,000 notional value. Someone looking to eventually buy $500,000 in exposure (or for an institution $5mm), can buy in bite-sized pieces. (See my 2019 blog for discussion on taking incremental steps.)

Further, while my focus here has been on the Case Shiller home price futures that are traded on the CME, similar exposures are available for other cities via OTC home price index agreements using my Home Price Hedging Fund.^4

Feel free to contact me to discuss this blog, ideas on how to play home prices from the long (or short side) or any aspect of home price index derivatives.

Thanks, John

^1 Recall that none of my blogs are to be considered investment advice. I am merely using hypothetical examples of how the contracts work.  Please consult your investment adviser or FCM for the suitability of any investment in futures.

^2 -Recall that all Case Shiller futures settle on the index value released in the month the contract expires. Since Case Shiller indices reference a three-month period with about a two-month lag, the February contract settles on the index value that covers activity through December. Note also, that the contracts are specific to a point in time. That is, rather than arguing that "in time" home prices will rise or fall, the CME contracts settle on the value at a specific moment. So, "yes" home prices may get back to above spot -and it these contracts that might be more suitable to debate on a longer expiration contract -but for this illustration, I'm only focused on where specific home price indices might be at a specific point in time.

^3 The examples shown illustrate the P&L if positions are held to expiration. I make no representations as to where prices might wander before expiration. Changes in prices before expiration may result in margin calls, or losses, should you decide to sell your exposure before settlement.

^4 While I can offer bullish hedges on many cities, not all cities (to include many in the Mountain States) would be offered at a discount to spot.