In past years, for many readers that wanted to hedge an exposure in an area that isn't referenced by a CME Case Shiller home price futures contract, I've pointed out that the 10-city index might be a "good enough" hedge. That's because prices had moved together, as the factors that drove home prices in one area often had similarities to other parts of the country, and therefore the country as a whole. After all, with securitization as the take-out for most fixed-income mortgages, we've had national mortgage interest rates, national arbiters of credit (e.g. FNMA/Freddie, Moody's/ S&P) ever-more national-based companies, with modest migration patterns where new homebuyers had not swamped one area, or depleted another.
In the diagram below, I note (to the right) how, between 2014 and 2020, annual price changes in the Freddie Mac NSA home price index for Pittsburgh had a >75% correlation with movements in the Case Shiller 10-city index. The stability of that correlation can be seen in the graph of the ratio of the Pittsburgh index vs. the 10-city index. Yes, there are separate approaches to how each index is calculated, but one could have drawn the conclusion, during this timeframe, that hedging Pittsburgh home price exposure with the CME Case Shiller 10-city index contracts would have been a "pretty good" hedge.
However, with Covid, and a preference for more space, and a change to work-from-home, all while the Millennials opting to settle in different areas, the risk of local prices moving different from the 10-city index has grown. The ratio of Pittsburgh to 10-city index has dropped, consistent with other "in favor" areas of the country having much higher home price gains than Pittsburgh.
To address the issue of growing regional vs national risk , I'm offering HPHF Ratio Agreements ("RA"). At a high level these allow users to express a view (e.g. add/reduce/hedge/speculate) on the ratio of a regional index vs the Case Shiller 10-city index at some point in the future. In effect, one can use the RA to hedge the performance of one region vs a more national market, and then hedge (if they care) the absolute performance of the 10-city market using the CME futures.
If one has strong views on the Pittsburgh/10-city ratio (e.g. that it will reverse when Covid ends, or that Millennials will flock there for the combination of more affordable housing and jobs in the Medical Industry, or as a Global Warming play (?!?) a RA might be the best way to express such views.
As with other HPHF Agreements, the exposure is bounded (with the use of caps and floors on the ratio) to calculate upfront the total exposure one might have on the Ratio Agreement. (see June 15, 2021 blog for an example referencing Chicago, and the HPHF page, for details on the structure of an RA.
I've shown levels here for Pittsburgh for Feb 2023 expiration, but I'm game to discuss most of the largest 50 cities that are referenced by Freddie Mac indices, and longer expirations.
Feel free to contact me if you have questions about this blog, have cities that you'd like to hedge (+/-) or if you'd just like to learn more about the use of home price index derivatives in hedging strategies.
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Thanks,
John