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Hedging Your Real Estate Investment/ Betting on the Bubble Bursting

Here's a slightly dated article on new instruments that Robert Shiller, an economist out of Yale, is creating to hedge against real estate price declines.  The indexes will be listed on the Chicago Mercantile exchange and rumor is that LA will be the first test market.  Can't wait until they create one for the Bay Area!

Another set of derivative products linked to home prices was introduced in October by HedgeStreet, which specializes in online trading of pint-sized contracts it calls ''hedgelets" for each of six cities: New York, Miami, Chicago, Los Angeles, San Francisco and San Diego.  However, these "bets" are only for $10 which, unless I'm missing something, make them all but worthless

======================================

December 12, 2004 Sunday Times

IF you have owned a home for several years, you may be sitting on a sizable increase in equity. And if you are worried that the run-up in housing prices can't last much longer, you may think the only choice is to call a broker, rent a moving van and head for the (less expensive) hills.

But through an increasing number of new investments, you may be able to limit future erosion of your home's value.

Macro Securities Research, a company affiliated with Robert J. Shiller, the Yale economist, has reached an agreement with the Chicago Mercantile Exchange to list pairs of derivative instruments that are essentially index funds linked to home prices in certain markets. One instrument in each pair will rise as its market index rises; the other will rise as the same index falls. That will let investors bet on the direction of housing prices. Similar, but less sensitive, vehicles are being offered by HedgeStreet, a firm in San Mateo, Calif., that offers small-scale derivatives speculation online.

For homeowners looking for alternatives to the risks and complications of derivatives trading, there are also insurance policies that pay out if home prices fall, but they are only available in certain areas, and the conditions for collecting are highly restrictive.

In fact, none of these approaches are likely to provide anything close to a perfect hedge, eliminating all risk of loss. And while the options available to nervous homeowners are growing in number and sophistication, some advisers warn that they may provide minimal protection from the vicissitudes of the real estate market.

But other, simpler strategies may help you prepare for a softening of the market, they add. One is to avoid variable-rate mortgages before any serious increase in interest rates -- an event regarded as a possible trigger for a reversal in home prices.

Macro Securities hopes to list its instruments in Chicago before such a reversal, but the exchange's announcement this month was short on details, like a starting date. Mr. Shiller, the company's chief economist, said that his securities would track home price indexes in cities yet to be chosen, although strong candidates include New York, Los Angeles and Las Vegas, he said.

The minimum investment for the securities and the amount of leverage built into them are also not yet known. A one-percentage-point move in the index, he said, may produce a change of two percent or three percent in the value of the securities.

An important feature of the Macro securities, he said, is that they will come in twos -- one moving in tandem with the index and the other in the opposite direction. Having a single index fund would require a hedger to sell short, raising the theoretical prospect of an infinite loss. (That could happen only if housing prices rose to infinity -- not a far-fetched idea to many people who are looking to buy a co-op in Manhattan.)

Another set of derivative products linked to home prices was introduced in October by HedgeStreet, which specializes in online trading of pint-sized contracts it calls ''hedgelets.'' Each is a yes-or-no wager that a housing index will be in a certain range on a given date within three months. After that period, the contracts expire, and losing bets are worthless.

There are three residential property bets, representing percentage moves in an index whose level may be higher, lower or even with the recent trend in home price movements, for each of six cities: New York, Miami, Chicago, Los Angeles, San Francisco and San Diego.

But the value of each contract is a paltry $10, and they are infrequently traded, at best, so unless you live in a matchbox, it would be difficult -- and very expensive -- to buy enough of them to provide a practical hedge.

Russell Andersson, a vice president of HedgeStreet, said that the products were new and were still seeking an audience. He conceded that their three-month life span was too fleeting for use by many homeowners and said that HedgeStreet was planning to introduce vehicles that would trade much like futures contracts and last for one and three years.

''With a combination of these two products, you can hedge out very aggressive short-term movements as well as longer-term movements,'' Mr. Andersson said.

Mr. Shiller says his approach to defending against price declines is meant to be useful even for people with modest incomes. ''We're looking for a vehicle with widespread acceptance,'' he said. The device of two separate funds is one way to gain it, in his opinion. ''It means there is no loss beyond the initial outlay, no margin calls,'' he said.

That may not be true if leverage is built into the instruments, as Mr. Shiller envisions. But homeowners looking for further protection may consider borrowing against their equity, knowing that it will rise enough to make up any decrease in the fund's value, he said. Should home prices fall, the value of the fund that is inversely correlated to the housing market will rise, mitigating the loss.

''Volatile markets are increasingly becoming a part of our lives,'' Mr. Shiller added. ''The home market itself is becoming more volatile. We're in the biggest real estate bubble in history, I believe.

''We haven't seen a swing down yet, but it could be coming,'' he warned. ''There are people with big houses and big mortgages who are going to feel the pinch.''

Jonathan Golub, a strategist at J.P. Morgan Fleming Asset Management in New York, agreed. The culprit in a downturn, he believes, will be big mortgages, more than big houses. Variable-rate mortgages, in particular, could be a problem.

When interest rates are low, buyers can afford more house for the same monthly payment, said Mr. Golub, who himself is a renter in Manhattan. He said that any holder of a variable-rate mortgage must understand that ''if interest rates drop, the house is worth more to me, and vice versa; if rates rise, I'm toast.''

Burned on both sides, too, because the higher mortgage payments tend to depress home prices. ''You get hit with a double whammy,'' he said. ''The cost of carrying goes up and the value goes down.''

NATIONWIDE, he noted, home prices rose 7 percent a year, on average, from 1999 to 2003, roughly double the rate for rental prices. Over the previous 15 years, the two rose more or less in tandem, with one outpacing the other for a while before the pattern reversed.

Mr. Golub says he expects home prices to hold up until mortgage rates rise further, so there is time for homeowners to prepare. His advice is to ''lock down that fixed-rate mortgage.''

As for the hedging vehicles being offered, he has doubts about their utility for most current and prospective homeowners. ''The adviser who would sell them won't be able to understand them,'' he said. ''They're the kind of thing you see pushed at the top of a market.''

For someone considering buying a home now, ''the smart thing to do is rent,'' he said.

''It probably does not make sense for someone who owns a home and plans to stay there to sell it and rent it back,'' he added. ''But what probably makes sense is for that first-time homebuyer or guy planning to retire to Florida to rent instead of buy.''



URL: http://www.nytimes.com

Real Estate Bust II?

Again, a real estate bust is unlikely.  Check out the attached report from the Federal Reserve Bank of New York.

McCarthy, Jonathan, and Richard W. Peach.  "Are Home Prices the Next 'Bubble'?"  FRBNY Economic Policy Review/Forthcoming.  June 2004

Download FRBNY.pdf 

Real Estate Bust?

Interesting article re: real estate bubble.  The net of it is that typically RE slows occur as prices stagnate (rather than decline) for long periods of time.   "Busts within a five-year window of booms only occurred in 9 of the 54 boom episodes identified prior to 1998, or roughly 17 percent of all such events. "

Clearly, the lion's share of home-price booms have not ended in busts historically," the report states.  That leaves 45 booms that did not see a subsequent bust, according to the report"

That being said, the prospects of flat growth, risk of bubble may make one wonder whether it’s time to take some capital gains off the table.

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Will this housing boom go bust? FDIC investigates causes of house-price booms

Wednesday, February 16, 2005

By Jessica Swesey, Inman News 

The rapid rise in

U.S.

home prices, increasing almost 50 percent overall over the last five years, has created a hot-button debate over whether Americans are staring at a possible home-price collapse.

The growth in home prices over the past year surpasses any increase in the last 25 years, according to data released by the Office of Federal Housing Enterprise Oversight, which tracks average quarterly house-price changes. Some economists have raised an eye to this unprecedented run-up in prices, saying it may be cause for concern.

In evaluating what the recent housing boom could mean for the nation's homeowners, the FDIC in a report titled, "U.S. Home Prices: Does Bust Always Follow Boom?" attempts to define housing booms and busts and considers what causes them. The FDIC finds that while home-price booms cannot sustain forever, not all booms end in busts.

Sixty-three

U.S.

metropolitan areas experienced at least one housing boom since 1978, and 24 cities experienced more than one boom, according to the report. The FDIC defines a "boom" as a 30 percent or more increase in inflation-adjusted home prices during any three-year period.

"Geographically, home-price booms have been concentrated in cities in

California

and the Northeast, which account for almost 70 percent of our 63 boom markets," the report states.

The FDIC defines a "bust" as an inflation-adjusted price decline of 15 percent or more in five years. Using these criteria, some 21 cities were found to have experienced a housing bust at some point over the last 25 years.

The report identifies two "major episodes" of home-price busts, the first taking place in the mid-1980s in the "oil patch" cities of

Texas

,

Oklahoma

,

Louisiana

and some other western states. This episode had some of the most severe price declines found in the report, with prices in one city falling by as much as 40 percent over a five-year period.

The second incident of major price declines occurred in the Northeast and

California

in the early 1990s.

The report notes that no cities are currently experiencing home-price busts. However, judging by historical events, we won't know for a few years whether the recent post-boom cities have safely avoided a bust.

And according to the report's criteria for booms and busts, home-price booms "only infrequently" lead to busts.

Busts within a five-year window of booms only occurred in 9 of the 54 boom episodes identified prior to 1998, or roughly 17 percent of all such events. "Clearly, the lion's share of home-price booms have not ended in busts historically," the report states.

That leaves 45 booms that did not see a subsequent bust, according to the report.

"In these cases, nominal home prices rose by an average of 2 percent per year during the five years after the boom ended. The equivalent figure for real home prices was a modest 2 percent per year decline," the report states.

In 83 percent of the post-boom cities, prices continued to increase at a slower rate and any declines after inflation were modest, according to the report. "Home prices in these markets simply stagnated, or stalled out, following their booms rather than going bust."

Housing booms that have ended in price busts were associated with localized economic stress, including recession and job loss.

The FDIC noted two case studies to illustrate this point, including the case of the oil patch cities in the mid-'80s, and the busts seen in

California

and the Northeast in the early '90s.

In the case of the oil patch cities, oil-producing areas of

Texas

,

Oklahoma

,

Louisiana

,

Colorado

,

Wyoming

and

Alaska

experienced an economic boom and population inflows while oil prices were rising in the late 1970s. That, in turn, caused the demand for housing to boom in these areas, increasing home prices. Then in 1980, when oil prices began a six-year decline, the local job markets and economies suffered.

"This economic stress, in turn, weighed heavily on the housing markets in these cities. In the worst cases, nominal home prices fell by 40 percent and 33 percent in Lafayette, Louisiana, and Casper, Wyoming, respectively, between 1983 and 1988," the report states.

In the case of

California

and the Northeast, similar elements of economic stress precipitated home-price busts, according to the report. A recession in the early 1990s, massive defense downsizing, a significant commercial real estate collapse, and a sharp downturn in population growth all were factors.

Although the FDIC demonstrates that few metro-area housing booms have ended in busts historically, the report notes reasons to believe history may be an imperfect guide to today's situation. It notes changes in credit markets, such as the emergence of the subprime market, that are pushing homeowners and housing markets into uncharted territory.

In addition, home buyers increasingly are taking advantage of higher-leverage mortgage products. In 2003, loans exceeding 80 percent of the home price accounted for almost one-third of all purchase mortgages. The practice of raising the total loan amount to a level very near the value of the home makes borrowers more likely to default if there is a housing market downturn.

"An increased incidence of default and foreclosure could, in turn, contribute to downward pressure on home prices as distressed properties are liquidated by lenders. However, little is known as yet about the effects these credit-market changes might have on the dynamics of boom-bust cycles," the report states.