Category Archives: derivatives

Credit Crunch Weighs on Housing Prices

Standard & Poor’s today released its S&P/Case-Shiller U.S. National Home Price Index for August 2007, and the credit crunch that recently roiled the mortgage market weighed heavily on home prices. Of the 20 markets tracked by the index, only five remain in positive territory over the past year.

However, the rate of appreciation in those markets has slowed, and even Seattle, the strongest market, showed a small monthly price decline. In fact, only two markets — Charlotte and Denver — showed a price increase for the most recent month.

Seattle is still up 5.7 percent for the past year; Charlotte is close behind at 5.6 percent; and Portland is up just 2.8 percent. Atlanta and Dallas are basically flat with 0.8 percent and 0.5 percent increases, respectively.

The worst-performing market had previously been Detroit with a 9.3 percent decline, but that dubious honor now goes to Tampa, which is showing a 10.1 percent decline over the past year. Previously hot markets including Los Angeles, Washington, D.C., Las Vegas, Miami, Phoenix and San Diego are all down more than 5 percent. The Composite Index of 20 markets was down 4.4 percent overall.

 oct-07-index-values.jpg

So where are we headed in the future? Investor expectations are reflected in housing-price futures and options traded on the Chicago Mercantile Exchange, which are based on a subset of the S&P/Case-Shiller U.S. National Home Price Indices. Expectations of future price changes are implied by the percentage difference in the index value for the relevant market (most recently published on Oct. 30, 2007, for August 2007 period) and the current price of traded futures contracts expiring on future dates.

Right now, investors are betting on a decline in the composite index of 7.6 percent by July 2008 (the futures contract expiring in September 2008 settles based on that period). They expect the index to still be down by 9.4 percent even in 2011. The most dramatic declines are expected in Miami with a decline of over 26 percent by 2011 and in San Francisco with a decline of over 25 percent by 2011.

oct-07-implied-prices.jpg

As always, remember that these contracts are new and thinly traded relative to well-established foreign exchange or commodities contracts, and that means they are reflective of the collective wisdom of fewer investors.

For example, investors are currently expecting a decline in the Denver market of over 7 percent by late 2008, but that market has logged three month of successive price gains. Unlike coastal markets, Denver did not experience outsized appreciation and so the downturn has been very moderate. In this case, investor pessimism may be misplaced and result in losses on those contracts.

 This article was also published by Inman News.

Forecast Calls for Pain

Last week futures contracts and options based on the S&P/Case-Shiller U.S. National Home Price Index with durations of more than 12 months began trading on the Chicago Mercantile Exchange.  Based on prices for contracts expiring during the next several years, investors expect deep housing price declines to continue. Investors expect the ten-city composite index to be down almost nine percent by September 2008 and over 11% by September 2009 before beginning a slight upturn for 2010 and 2011.  The ten markets on which CME contracts are currently traded are mostly coastal — except for Chicago, Denver and Las Vegas – so the composite is likely showing a deeper downturn than would a more national index covering stronger markets like Seattle or Raleigh-Durham.  Investors expect the worst performing market to be Miami with a breath-taking decline of over 29% by September 2011.  San Francisco is also expected to decline more than 20% and San Diego and Las Vegas just short of 20%.  Chicago is expected to see the smallest decline which is natural since that market also experienced relatively limited price appreciation compared to coastal markets. 

Are these expectations reasonable or the narrow perspective of a small set of panicked investors?  The Los Angeles market began its ascent in April 1996 and climbed steadily before hitting its peak in September 2006. Over that more than 10 year period, housing prices increased about 275%.   Since hitting its peak, the LA market has declined by 4.8% as of July 2007, the most recently published S&P Case Shiller index value.  CME futures investors expect a further decline of almost 15% by 2011, for a total decline of just under 20% over a period of more than five years between the market peak in July 2006 and September 2011.  The prior downturn in the LA market lasted almost six years from June 1990 to March 1996 and the decline from peak to trough was over 27%.  On that basis, investor expectations seem reasonable, at least for Los Angeles.

The Miami market began its last upturn in September 1992 and peaked in December 2006.  During that period housing prices increased about 262%.  Again, put in that context, current investor expectations don’t seem unreasonable.  As many folks who joined the industry in the past few years are discovering, the real estate market — like other markets – doesn’t move in just one direction.

 Note: Future price expectations are reflected in the difference between the current index value (most recently published for July 2007) and the prices of contracts expiring at future dates.  Contracts expiring in November are based on the index value with a two month lag so price expectations for September 2008 are reflected in the contract expiring in November 2008. The contract prices above are as of 9/25/07.

 This article was also published in Inman News.

Long-Duration Derivatives Begin Trading

Long-duration derivatives based on two competing housing price indexes began trading this week. These new contracts with expirations between one to five years will allow investors, developers, builders and other market participants to express a long-term view on U.S. housing prices.

Contracts based on Radar Logic’s Residential Property Index (RPX) will be available through licensed dealers including Morgan Stanley & Co., Lehman Brothers, Merrill Lynch, Pierce, Fenner & Smith Inc., Deutsche Bank Securities Inc., Goldman Sachs & Co., and Bear Stearns & Co.  These indices cover 25 local market areas.

Futures contracts and options based on the S&P/Case-Shiller U.S. National Home Price Index with durations of 12 months or less have traded on the Chicago Mercantile Exchange since May 2006. Contract months extending out 18 months will now be listed on a quarterly cycle of February, May, August and November. Contracts listed 19 to 36 months out will be available on a biannual schedule of May and November contracts. An annual November listing schedule will apply to contracts listed 37 to 60 months out into the future.

Contracts based on the S&P/Case-Shiller indices trade for 10 markets: Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York City, San Diego, San Francisco and Washington D.C. 

Investors that own large portfolios of mortgage-backed securities may be some of the first customers for these products. According to Rich McKinney, head of Residential MBS Trading at Lehman Brothers, “Investors holding securities sensitive to mortgage credit and prepayment performance … now have a powerful tool in managing their residential real estate risk.”

The importance of housing prices for holders of residential MBS securities was recently highlighted in an article from the forthcoming Federal Reserve Bulletin that analyzed loan data from 2006 collected under the Home Mortgage Disclosure Act. The data comes from 8,900 lenders that account for an estimated 80 percent of home lending nationwide.

The study found that the best predictor of future loan performance on a county level was not the unemployment rate, per capita income or population growth. The most important predictor was house-price appreciation. And conversely, risk to holders of these securities comes from house-price depreciation or – as it is often referred to oxymoronically in the industry – negative price appreciation.

This article also was published in Inman News.

CME Futures Contracts – Weekly Update

Below are closing prices for CME Futures contracts as of Friday September 7.  Longer duration contracts for only two markets – Chicago and Las Vegas – have traded so far.  Investors continue to take a very pessimistic view of these markets, expecting all to decline by the August 2008 expirations.

The worst is a 10% decline expected in Miami.  This is pretty dramatic when you think about it.  The median home price for the Miami market published by NAR for the 2nd quarter was $384,400. Most home buyers put down 20% or less to purchase a home.  A decline of 10% would wipe out about $38,000 in equity.  If you did an 80/10/10 mortgage program, all of your equity would be gone within 12 months and, with closing costs, you would be upside down on your financing.

 The only way for home buyers to protect themselves would be to buy at a very deep discount to the current market price. And of course that kind of mindset, if held widely, would only add downward pressure on prices.

Implied Prices Table 9-7-07

Housing Prices – Monthly Update

Last week housing price futures contracts expiring in August 2008 began trading on the Chicago Mercantile Exchange and investors appear to have taken all the recent bad real estate news to heart.  Investors are expecting deep declines in many formerly hot markets with Miami expected to fall 9.4%, Las Vegas 9.2% and Los Angeles 8.4% by the end of the second quarter of 2008.  Markets expected to fall the least are Chicago at 5.3%, Denver 6.6% and San Francisco 6.8%.  For the overall 10 city composite index, prices are expected to fall 6.4%. Investor expectations are reflected in housing price futures and options traded on the Chicago Mercantile Exchange which are based on a subset of the S&P/Case-Shiller® U.S. National Home Price Indices.  These property derivatives are traded on indices for a ten-market index and the component markets of that composite.  Expectations of future price changes are implied by the percentage difference in the index value for the relevant market (most recently published on August 28, 2007 for  June 2007 period) and the current price of the four traded futures contracts expiring in November 2007, February 2008, May 2008 or August 2008.

Implied Prices Aug 07

So how do investor expectations compare to recent housing price trends?  This week Standard & Poor’s released its S&P/Case-Shiller® U.S. National Home Price Index for June 2007.  The composite index of 20 markets was down 3.5% over the twelve month period from June 2006 to June 2007.  The 10 city composite was down 4.1%, so investor expectations of a housing price decline of 6.4% by the end of the 2nd quarter of 2008 imply a significant acceleration in the rate of decline. As always there are large differences in housing price trends in local markets.  Of the 20 markets tracked by the indices, 15 showed price decreases and 5 showed price increases over the last 12 month period.  Seattle was up 7.9%, Charlotte 6.8% and Portland 4.5%.  Both Atlanta and Dallas showed a nominal increase of 1.6%. Several markets were down dramatically with Detroit off 11%, Tampa 7.7%, San Diego 7.3% and Washington, D.C. 7% during the 12 months between June 2006 and June 2007.  

Aug 07 Index Values

The composite index and its regional sub-indices use the repeat sales pricing technique to measure housing markets by collecting data on single-family home re-sales, capturing re-sold sale prices to form sale pairs. Price appreciation or depreciation is more accurately reflected by the change in value of the same properties over time across entire market areas rather than the more volatile median home prices published by NAR.  

As always, it’s worth remembering that the CME futures contracts are thinly-traded relative to much more established contracts for commodities and foreign exchange so they reflect the collective wisdom of fewer investors.  But it’s one more data point for your crystal ball and not one that leads to a very optimistic conclusion about the future direction of the real estate market.


This posting also appeared as my monthly column on Inman News.

Radar Logic Licenses RPX Index

Last week, another player launched a set of residential property indices in the race to enable trading in derivative instruments and financial products. Morgan Stanley, Lehman Brothers and Merrill Lynch signed licensing agreements with New York-based Radar Logic Inc. for its Residential Property Index, or RPX.

Radar Logic uses proprietary modeling techniques to create “daily prices” derived from actual prices paid for U.S. residential real estate. The indices are based on the price per square foot in 25 markets and a composite index, and will be published nine weeks after the actual closing date. The indices will be published each day for several time periods: daily, seven days and 28 days.

Also last week, the Chicago Mercantile Exchange announced that housing futures and options contracts based on the S&P/Case-Shiller U.S. National Home Price and Composite Indices would be extended out to five years. These indices are published each month for a one-month period. The most recently released indices were published on July 31 for the May 2007 period.

The S&P/Case-Shiller and RPX indices differ not only in timeliness but also in market coverage and methodology. The S&P/Case-Shiller indices cover 20 markets (with CME contracts only trading for 10 markets) while the RPX indices cover 25 markets. The S&P/Case-Shiller indices use the repeat sales pricing technique to measure housing markets by collecting data on single-family home resales, capturing resold sale prices to form sale pairs. The indices track the appreciation or depreciation occurring for resale properties across a market area but do not include condo, new home or foreclosure sales.

The RPX indices are computed based on price per square foot — not just sale price — and include resale, foreclosure, condo and new-home property transactions. The “daily prices” are likely to be quite volatile based on the actual sale prices paid for properties sold on a specific day nine weeks prior to the actual publication date. The results will not be adjusted for seasonality.

Both sets of indices are being used by Wall Street to create new financial products to enable trading, for hedging or speculative purposes, in the residential real estate market. According to Federal Reserve statistics, the aggregate value of residential housing assets was $22.9 trillion as of March 31, 2007. That’s larger than the U.S. equity market.

For property investors, developers and owners, these tools should ultimately mean lower risk and greater efficiency. According to Michael Feder, president and CEO of Radar Logic, “Property developers usually negotiate interest-rate caps to manage their rate risk on condo developments, and now they will be able to buy a series of puts to essentially lock in prices for a development before breaking ground.” This is very much as farmers lock in prices for all or part of their crops at the time of planting. Right now a lot of home builders with rapidly decreasing book values would probably liked to have hedged the price risk on their new home or condo developments a couple of years ago.

This article was published in Inman News.

Long-duration housing-price derivatives debut

The Chicago Mercantile Exchange last week announced that housing futures and options contracts based on the S&P/Case-Shiller U.S. National Home Price and Composite Indices would be extended out to five years. Trading of these contracts is scheduled to begin on Sept. 17.

Contract months extending out 18 months will be listed on a quarterly cycle of February, May, August and November. Contracts listed 19 to 36 months out will be available on a biannual schedule of May and November contracts. An annual November listing schedule will apply to contracts listed 37 to 60 months out into the future.

The CME began listing housing futures and options in May 2006. The 10 cities include Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York City, San Diego, San Francisco and Washington, D.C., in addition to the composite index containing all 10 cities.

These short-duration contracts have been very thinly traded compared to mature markets like commodities and foreign exchange. The slow growth has been due to the fact that residential real estate is often a long-term investment. Property developers, builders and other investors need tools that allow them to hedge risk over multiyear periods. The contracts initially listed in May 2006 only had durations of up to 12 months.

Fritz Seibel, director of property derivatives at Tradition Financial Services, “expects the U.S. housing futures market to trade in a two- to three-year forward ‘sweet spot’ that reflects the natural timetable of housing. This sweet spot allows for a change in the equilibrium of the housing market (changes in housing inventory, starts, permits, sales, demographics, credit, etc.) to manifest itself in housing pricing. It is as if the spot market for housing is some two years in the future at any given time. These future prices will be discovered through trading.”

For real estate pessimists who want to speculate on an extended downturn in the market, these contracts provide a vehicle as well. Residential real estate markets, unlike stock markets, are often characterized as “sticky downwards.” If homeowners don’t get offers they like, many choose to simply take their home off the market until demand firms up and prices rise.

As a result, real estate slumps can last for extended periods of time. For example, the last major downturn in the Los Angeles market lasted nearly six years, beginning in June 1990 and continuing until March 1996. During that period the market declined just over 27 percent.

This article was also published on Inman.com