Sunday, December 12, 2004

Investments provide a new way to hedge home's paper profit

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 can take steps 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 likely 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. 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 1-percentage-point move in the index, he said, may produce a change of 2 percent or 3 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," Andersson said.

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 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," 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 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.

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."

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