Week 4 of March. Volatility update and logistical issues

I posted a blog on March 21 with some graphs of how the Case Shiller home price futures had changed over the prior month (Feb 21 to Mar 21). Given current market volatility, let me review what's happened just in the last week.

There are so many angles to the question of "what's happened" and "what does this market say about where home prices might be headed" that I've decided to divide my ideas into separate blogs. Some themes have had an impact other aspects of the market. I'll introduce such segments here, to give an overview of how they influenced activity this week, but will delve into them in more detail in the near future.

Here's some themes to be aware of:

1) The graphs from Mar 21 can't be replicated this week because I paused on quoting bids and offers across all February expirations. Much of this is due to the increase in margin calls (see below) but given the market's spike in volatility, ever-wider bid/ask spreads would have been appropriate. However, at some point, I'm not sure of the utility of posting ~20-point bid/ask spreads (on longer-dated contracts). My view is that price discovery needs to be fleshed out in shorter-dated contracts (e.g. Feb '21) before extending narrower bid/ask quotes to longer contracts via calendar spreads. Until then, I'm very open to brokering inquiries on G24/G25 contracts (and have two parties looking at opposite sides of the HCI (10-city)), so activity is likely to continue. Closes are still being calculated, but I'd discourage users to give them undue weight on longer-term expirations, and contracts that I haven't been posting quotes (e.g. Nov '22).^1

2) Interactive Brokers ("IB") raised initial margins on contracts to ~20x what the CME requires, to ~40% of the notional value of contracts, and in my case to 40x what they estimate as 1-day VAR (at >99%). While I appreciate their need to manage risk, I would estimate that IB brokered >75% of all Case Shiller trades in the last year. As such even though there are other firms (Insignia Futures and Schwab) that have not raised margins much at all, IB's actions impacted many users with open positions (as maintenance margins have also risen), may have discouraged their clients to the opening of new positions.^2

3) Much of recent activity (including mine and several users) seems to have unwinds of current exposures, and/or trades to move positions to other brokers. I tally 55 lots being traded in March, and while that normally would result in an increase in open Interest ("OI") the level of OI today (49) is the same as it was on Feb. 29th. Net while there may have been users who traded CME Case Shiller futures as one leg against other markets,or to take an outright view, my sense is that many trades may have been done just for logistical reasons related to margin. As such, please take volume figures with a grain of salt.^3

4) With bid/ ask spreads wider, and volatility high/liquidity low/ the need to focus inquiries on fewer expirations should increase. Recall that there are 110 CME Case Shiller contracts (11 regions * 10 expirations) while with stocks, bonds, and foreign exchange users often just trade the front contract. Multiple expirations have two negative consequences during volatile times: a) they disperse users across many contracts, and b) trading multiple expirations via calendar spreads opens two new positions that add to much higher margin requirements. As such, while I've historically posted >100 calendar spreads at one time, for now, I'm going to focus -and would ask users to focus -on a limited number of expirations. I will be posting bids on May 2020/ K20 (the front contract), Nov 2020/ X20 (as that contract has legacy positions and will reflect the impact on home price changes during this summer), Feb 2020/ G21 (my benchmark contract that is: a) one-year forward, b) the contract that references 2020 year-end index values, and c) will be the front leg for calendar spreads to later years), and finally Feb 2023 (to given users a platform to debate the intermediate impact of the new economy on home prices).

In addition, I will tout the Feb 205 (G25) contract, as this might be the best, public platform for expressing a view on longer-term home price projections, but I may not be posting aggressive bids and offers. Forward markets will be highly dependent on how one envisions "life after Covid", and will likely remain highly volatile as health issues evolve, rumors of vaccines or treatment spill out, and how the government stimulates the economy, aids borrowers, and treats the housing sector.

I hope to expand to coverage of 6-8 expirations, once volatility abates, there's good price discovery (to include participation by third-parties in benchmark contracts), and margin costs fall back to near historic levels.

5) CME Case Shiller prices have been very quiet (at least in the front four expirations) relative to the roller-coaster rides in the general stock market, or in housing-related stocks (e.g. brokers -Zillow, builders -ITB, buy-to-rent programs -INVH). While some of the price stability in the Case Shiller futures is probably due to illiquidity of these contracts, and some of that has been the absence of others pushing up or down prices from the levels I've posted, my sense is that there's a bigger issue (to be fleshed out in more detail in a future blog) of when home prices might be impacted. Since the Case Shiller index is a moving average over three months, and then lagged two months, I'm hard-pressed to see a big impact on May '20 (K20) contracts. The Aug '20 (Q20) and Nov '20 (X20) contracts benefit from seasonal factors and the probability that few owners/tenants will be tossed from their homes for not paying mortgages/rent before Election Day. However, after that (and depending of course on how the virus plays out), home prices may be quite a bit more "fluid".  

I've tried to keep readers informed on where I think the Feb '21 (G21) CME Case Shiller contracts might clear, and also to display user trading axes, on one of my website pages.^4

Here's my post from Friday just after noon:

I'd note that all but one Feb '21 contract (BOS) is offered below spot levels. While BOS has fared the best, the LAV contract has fallen the most, and is offered at the biggest discount to spot. As I've noted before, while the contracts will converge to index values, contracts also are valued by where risk clears. Given the heightened concern about our economic future, I'm not surprised to have seen an increase of inquiries from readers looking to hedge home price risk. (More on that, and the need for an options product, and in particular, writers of options, in future blogs). As such, it may be the case that the futures have dropped more than expectations. On the other hand, given the lack of a spot market in home prices, the public may not have a tool to measure the decline in expectations (as survey results can only be updated periodically). Cynically, it may also be the case that parties interested in stable/growing home prices, and continued housing turnover (i.e. homeowners, brokers, mortgage lenders, developers) may have less interest in suggesting that home prices are headed lower.

I've also started quoting G23 (Feb '2023) contracts (not shown here, but with wider bid/ask spreads, using a combination of calendar and intercity spreads.

I'm expecting performance across regions to start deviating from the highly correlated patterns of the last few years as, even after Covid, as job losses in certain regions (e.g. Las Vegas) may suffer as new norms in business travel change. (More to follow in future blogs).

In sum, there's been a lot going on, with many 1:1 conversations over trading strategies. Please feel free to contact me on any issues related to this blog, if you have themes that you'd like to see discussed in the future, would like to share trading axes, or if you have any questions on the use of home price index derivatives.

Thanks, John

^1- As I've written before, the CME rule on establishing closes on the Case Shiller futures is the last trade, or a lower offer or higher bid. With infrequent trades and offers going up, while bids head lower (or don't get posted), closes may reflect ever-less relevant information about where the next trade might take place. I maintain a ledger of shadow markets, and am open to sharing views on how I might quote markets. Please contact me, rather than relying on analysis based on closes.

^2-To see initial and maintenance margins charged by IB go to "Order Book" page. Right Click "Contract". Scroll down to "Financial Instrument Info". Click "Description". View details.

^3 -I've found users of open positions (via emails from the original trade dates) and have unwound open positions (for both of us). I've had users that have traded out of one position on one broker and into new ones at another. In addition, I confess to a "fat-thumb" trade as I've tried to master new programs.

^4 -See my March 17th blog for an explanation of the information on this site.