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April 24, 2006 6:35 pm

Hedge around your home

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The words would bring a mixture of pleasure and pain to any new homeowner. “You guys got a great deal,” crowed not one but three neighbours following the recent purchase of a condo in Chicago’s Lincoln Park.

The comments produced the same chill as “the great rehab opportunity” line that graced the realtor’s listing. The area’s gentrification was almost complete. The only way was down.

Lincoln Park is fairly representative of the country. The US housing market appears to be on the cusp after a prolonged boom. Most analysts predict a soft landing rather than a protracted crash but there are pockets where price appreciation is at unsustainable levels and where it appears a “bubble” is ready to burst.

A hard landing for the housing market, with many Americans funding their consumption with extra mortgages against the increasing value of their homes, could have severe knock-on effects on the economy. So this could be a good time for the launch of the Chicago Mercantile Exchange’s latest product. Next month, it will launch futures and options that can mitigate the risk of house price movements. They will also offer investors additional access to housing, an asset class topping $20,000bn – larger than the US equity market – which has hitherto been limited to trading of mortgage portfolios.

According to the CME, the scale of the market should attract institutional investors as well as offering a risk management tool for mortgage providers to hedge exposure to the home loan market. The contracts have been tailored at a size that anticipates demand from individual investors, who could take advantage of their relative expertise in the market in contrast to, say, precious metals.

“I think it’s going to be a big retail market,” says Russ Wasendorf Sr, founder and chairman of Peregrine Financial, a Chicago-based futures broker. “There are a whole lot more people in the US who own real estate than own [existing] futures.”

Familiarity aside, the launch of housing products has been held back by the absence of a reliable measure of house price movements. The CME products will be based on the Case-Shiller indices, developed by two economists in the 1980s and revised to provide a monthly benchmark of pricing in 10 US metro markets, as well as a national composite.

Robert Shiller, the Yale economist and expert in behavioural finance, found fame with his book Irrational Exuberance, which came out just before the collapse of the internet stock bubble in early 2000. Perhaps worryingly, he is now in the “bear” camp on housing.

The CME will offer futures and options based on house prices in New York, as well as Washington, Boston, Miami, Chicago, Denver, Los Angeles and San Francisco. Las Vegas and San Diego, two of the hottest real estate markets over the past two years and the source of feverish discounting by some new-home builders, are also included, and could create volatility.

Over the last five years, according to Case-Shiller, Denver house prices have gained only 20 per cent. In Miami, the increase has been more than 140 per cent. Miami is also the strongest market since the index began in 1987 and its appreciation has been double that of Denver in the period since.

Retail investors can use the futures in three main ways. The simplest, direct investment, lets you take a view on a housing market by going long if you think it will go up, or short if you think it is going down. This is not possible for all futures contracts. These will be settled in cash, unlike, for example, the CME’s frozen pork belly contracts.

A similar shorting strategy would allow homeowners planning to move within a limited time frame to lock in the current value of their property, with the contract paying out the difference, or at least part of the difference, if house prices decline before their planned move.

Each contract is valued at $250 multiplied by the index value. Thus to cover the value of a $500,000 home in Chicago, where in January 2006 the index stood at 163.98 – would require 12 contracts.

Finally, owners could link the value of their home to an index. For example, the home above could be listed at a constant 3,000 times the value of the Chicago index, tying its worth to the index and providing transparency to future buyers.

But some economists dislike the methodology of the indices, now known as the S&P Case-Shiller Home Price indices. They are based on recorded changes in home values based on a two-month “look-back” and released on the last Tuesday of each month.

Marc Chandler, an economist at Brown Brothers Harriman and a one-time trader on the floor of the CME, complains it does not provide a like for like guide to prices over time, notably because it excludes the impact of home improvement, which he says contributes to the disequilibrium housing has in the economy.

Mr Chandler suggests a truer reflection of house prices would require, for example, some proportion of sales at Home Depot to be factored in. Observers also question whether housing futures would be used as a risk management tool or as another speculative vehicle. Such things have happened in other markets.

A final question is whether there will be the institutional demand its proponents claim. The bulk of house price risk in the US lies with huge federal agencies such as Fannie Mae. Will they be willing to provide the initial liquidity in the fledgling market?

In spite of the intrinsic appeal of housing contracts, institutions will have to step in if the CME launch is to succeed. Retail financial advisers are suggesting clients wait a year or so before deciding on housing futures and options, rather than risk being left unable to sell in a market with little liquidity.

The new breed of online trading tools – notably in the options market – would at least afford potential users the opportunity to exploit virtual marketplaces as the housing market develops, without the risk of financial loss. However, options will be traded only in the CME’s pits. Only futures – which tend to be harder for retail investors to trade online – will be traded on its Globex electronic system.

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