Thursday, December 30, 2004

This bet’s on the house!

Expect a broad spectrum of companies being involved in covering realty risks

Financial Times

Homeowners around the world effectively gamble on home prices. Their risks today are often big due to real estate bubbles in such glamour cities as London, Paris, Madrid, Rome, Istanbul, Moscow, Shanghai, Hangzhou, Sydney, Melbourne,

Vancouver, Los Angeles, Las Vegas, Boston, New York, Washington, DC and Miami. Those bubbles may keep expanding, or may burst, leaving many homeowners mired in debt.

The risk to home prices in the aftermath of a bubble is real and substantial. In the last cycle of real estate busts, real (inflation-corrected) home prices fell 46% in London in 1988-95, 41% in Los Angeles in 1989-1997, 43% in Paris in 1991-98, 67% in Moscow in 1993-97, and 38% in Shanghai in 1995-1999. All of these drops were eventually reversed, and all of these markets have boomed recently. But this does not guarantee that future drops will have a similar outcome. On the contrary, the future real value of our homes is fundamentally uncertain.

Most homeowners are not gambling for pleasure. They are just buying real estate because they need it. But, because they do nothing to protect themselves against their real estate price risks, they are unwitting gamblers. In fact, home buyers in most countries do nothing to protect themselves — short of selling their homes — because there is nothing to be done. A market for real estate derivatives that can help balance these risks is only just beginning to appear. Well-developed markets for real estate derivatives would allow homeowners to kick the gambling habit. A liquid, cash-settled futures market that is based on an index of home prices in a city would enable a homeowner living there to sell in a futures market to protect himself. If home prices fall sharply in that city, the drop in the value of the home would be offset by an increase in the value of the futures contract. That is how advanced risk management works, as financial professionals know. But the tools needed to hedge such risks should be made available to everyone.

Attempts to set up derivatives markets for real estate have — so far — all met with only limited success. In May 2003, Goldman, Sachs & Co began offering cash-settled covered warrants on house prices in the United Kingdom, based on the Halifax House Price Index and traded on the London Stock Exchange. In October 2004, Hedgestreet.com began offering “hedgelets” on real estate prices in US cities — contracts that pay out if the rate of increase in home prices based on the OFHEO Home Price Index falls within a pre-specified range.

My former student Allan Weiss and I have been campaigning since 1990 for better risk management institutions for real estate. In 1999, we co-founded a firm, Macro Securities Research, LLC, to promote the development of such institutions, working with the American stock exchange to create securities that would allow people to manage real estate as well as other risks.

These will be long-term securities that pay regular dividends, like stocks, whose value is tied — either positively or negatively — to a real estate price index. Early this month, the Chicago Mercantile Exchange announced that it will also work with us to explore the development of futures markets in US metropolitan-area home prices. We hope to facilitate the creation of such markets in other countries as well.


The future real value of our homes is fundamentally uncertain
Home buyers in most countries do nothing to protect themselves
Leave the game of real estate speculation to professionals

Because even many financially sophisticated homeowners will find direct participation in derivative markets too daunting, the next stage in the development of real estate risk management will be to create suitable retail products. For example, the derivative markets should create an environment that encourages insurers to develop home equity insurance, which insures homeowners not just against a bust but also against drops in the market value of the home. Such insurance should be attractive to homeowners if it is offered as an add-on to their existing insurance policies.

Derivatives markets for real estate should also facilitate the creation of mortgage loans that help homeowners manage risks by, say, reducing the amount owed if a home’s value drops. Such products should appeal to homebuyers when the mortgage is first issued. Insurance companies and mortgage companies ought to be willing to offer such products if they can hedge the home-price risks in liquid derivative markets. Creating these retail products will require time, experimentation, and some real innovation. Over the next decade, we might expect that a broad spectrum of insurance, lending, and securities companies will become involved. As these retail products start to take shape, they will spur increased activity in the derivative markets. As the new risk-management industry develops, its components will gradually boost each other.

These developments offer hope that current and future homeowners will be spared the agony of worrying about the vicissitudes of the real estate market. They will be able to leave the game of real estate speculation to professionals and rest assured about the value that they have accumulated in their homes.

That is good news, because there is a pretty strong chance that we are going to see major price declines in a number of cities around the globe in the next few years, and these price declines will cause real pain to many homeowners. But if the momentum towards better risk management continues, it will be the last real estate cycle in which homeowners are unable to protect themselves.

The author is professor of economics at Yale University.


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