Housing Derivatives

Robert Shiller writes in defense of financial innovation, and James Kwak, Ryan Avent and Felix Salmon artfully take it apart.

My interest is in Shiller’s use of housing derivatives. Here’s Felix:

Shiller simply takes it on faith, however, that a nice liquid market can and should spring up to provide two-way prices in such risks, solving lots of problems at a stroke; he doesn’t stop to consider that maybe the reason such markets haven’t sprung up is precisely that there’s no real demand from anybody wanting to take on those risks. In reality, Shiller should know that better than anyone: his much-vaunted house-price derivatives have gone nowhere, partly because no one ever really had any need or desire to go long.

Shiller’s first proposed innovation is an attempt to deal with the regrettable move, in recent years, towards a “popular reliance on housing as an investment”. Only except for suggesting the obvious — moving people away from the idea of housing as an investment, and towards good old-fashioned renting — he comes up with a complex mortgage with all manner of embedded options. As with any derivative, those options will be a zero-sum game, and you can be sure the homeowner is going to end up on the wrong side of it. But Shiller still seems to think it’s a good idea for homeowners to buy them, instead of simply getting a plain-vanilla, easily-comprehensible mortgage, with payments which are set over the life of the loan and which are entirely predictable.

Shiller has been talking about this for a while, and I still don’t get it. There’s a lot of talk about derivatives as some sort of magic, but all they are is a secondary bet on the price of something, called an underlying. Their value is derived from something else. And one of the fundamental things about options is that you need to be able to buy or sell the underlying if you are able to effectively handle the risk of derivatives. One of the central insights of Black-Scholes that a derivative isn’t made of magic, it is just made with a position in the underlying and a position in cash.

Like oil. If the futures market spins out of control, you can always just buy the oil itself, store it, and deliver it in the future for the futures contract. That’s why there was all the drama with demand for oil tankers over the past year – people were hoping to buy the commodity now at the spot price and deliver it to futures customers. If these prices differ too much in equilibrium, we back out a “cost of carry” or a convenience yield. The prices are different because it costs some money to store that oil for the future, or because it is helpful to have in your pocket to deal with short-term fluctuations, etc.

How is this supposed to work with housing? What’s the “cost of carry” on a unit of housing in Los Angeles? Taxes, repairs, maintenance, insurance, etc. all add up really quick. What’s the transaction costs in quickly buying and selling a unit of the underlying? Brokers fees add up even faster. The fact that quickly buying and then dumping $1m in the underlying is very costly and takes a large amount of time – unlike oil – makes me think that there’s no way for this to ever take off as a real derivative market. And more generally, how could you ever have a net short position?

I have a lot of quant and options-smart readers, so someone explain to me how one is supposed to handle this? Is it even possible to go short, delta-hedge, or easily adjust housing risk at a hedge fund? If not, why are we putting any hope in this market getting some real juice in it?

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11 Responses to Housing Derivatives

  1. Hn says:

    as you say, delta hedging isnt possible , so quant desks cant make prices.. what is always possible, for any security, is to simply list it on an exchange, and let buyers /sellers agree on a price. Use some sort of a future on a non tradeable housing index, put it on an exchange, cash settled and tied to case shiller data, and if there is interest, well , a price will emerge..

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  3. Mike says:

    Hn – exactly, but prices aren’t emerging, and the market is incredibly thin on the few contracts that do trade. As opposed to, say, cattle – where there are cattle ranchers and people who want to cook/eat cattle who obviously want to sell to each other – there’s no obvious person on the other side on the trade. There’s lots of people who want to dump housing risk, but few people who want to (or could even reasonably hold a backstop for) housing risk.

    I, and a million other finance geeks and hedge fund traders, would all jump at the opportunity to get on the other side, if we could program computers to consistently hedge out our risks in the underlying, like you do for other options. Buy you can’t, and even if you could the transaction/carry costs are too high, and even if there weren’t you can’t have a net short position in any volume.

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  5. dsquared says:

    If someone (presumably Satan) actually gave me the job of making a pitch in these things, and I accepted (presumably either because I was in hell or was on a multi-year guarantee), I would “hedge” by buying and selling equity shares in REITs and housebuilding stocks, and pray.

  6. dsquared says:

    Oh, and I’d charge the most rapacious spread in order to make sure I was shoring up enough profits to pay for the inevitable hedging disaster, which is of course the whole point.

  7. Mike says:

    I’ve actually had some people tell me, in full sincerity, there are no limits to arbitrage in housing market as is since it is always possible to go short caterpillar and other stocks whose earnings are dependent on homebuilding. Next time I hear that I’ll add “and pray. Prayer should be be able to close any hedging gaps.”

  8. fresno dan says:

    It is well known that the monolines exaggarated the risks of municipal bonds, apparently to maintain the illusion of the utility of their ratings. If recent events teach us anything, it is how irrational humans are. Sears for years sold “maintenance contracts” for 20$ toasters…and people bought the contracts!
    Supposed sophisticated investors bought “securities” based on the obvious impossibility of ever rising home prices, rated by companies that were paid by the companies getting the rating, with the bonds insured by companies that had no means to make good in the event of default. There is more money than brains.

  9. charles says:

    For such market to take place in size, you need to create a natural buying and a natural selling interest. In the case of Case-Shiller indices, the natural buyers should be the households that are in the process of saving for their down-payment, and the natural sellers should be the homeowners that could link some of the principal of their mortgage to Case-Shiller level.

    To kick start the market, the Federal Govt would be well inspired to issue some debt linked to Case-Shiller (in the same fashion than TIPS, but without the implicit put). It would provide inflation protection to investors (you may even get the Chinese interested) and deflation protection to the government. Actually, if there was a Risk Manager in the Federal Government, s(he) would identify a big short exposure to Case Shiller through the no so implicit guarantee of GSE.

    On the other hand, the government may not like to see what a non-manipulated market based expectation of future Case-Shiller indices is. It is one thing to dismiss implied levels from an illiquid market in Chicago, another to discard an outcome of a government bond market.

  10. Andy says:

    My thoughts are similar to those of Charles. The natural participants are those who will be (within the derivatives’ horizons) entering or exiting the housing market. Or, more precisely, moving up or down in terms of $s invested. So I, as a Chicago renter, would be a natural buyer, while others (e.g., someone planning on moving from Chicago or planning on decreasing house size after the kids move out) should be a natural seller.

    The question is, are there enough expected entrances/exits to drive any kind of meaningful volume? I think the answer is no. The idea is conceptually appealing and I could realistically see myself buying a small long position, but I don’t think it will ever actually play out.

  11. Namazu says:

    Charles and Andy correctly identify the natural buyers, so there is demand for hedging on both sides of the trade. An imbalance in demand for hedging higher vs. lower prices will push the price of the derivative security to a level that speculators bring supply and demand back into balance. To the other part of your question, there’s no physical delivery because Shiller’s product isn’t an option, but essentially a futures contract on an published index–i.e., a simple side bet.

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