Housing Bets Attract Little Action

By Mary Ellen Slayter
Special to The Washington Post
Saturday, November 22, 2008

Your house may be special to you, but to a futures trader dealing in housing contracts, it's just another data point.

"At 10,000 feet, housing is a commodity," said Fritz Siebel, a broker at TFS Derivatives who specializes in housing-related securities. And housing futures are one way to hedge real estate investments.

When the Chicago Mercantile Exchange launched its housing futures and options market about two years ago, housing futures struck some investors and economists as an appealing way for real estate buyers to hedge against huge losses in equity. But those products have caught on slowly among institutional investors and even more slowly among individual investors. The reluctance of the latter is not necessarily a bad thing, financial planning and futures trading experts said.

The basic idea behind these products is to be able to bet on the direction of home prices, creating the possibility that a property owner -- in theory, even an individual homeowner -- could hedge against a sharp decline in a property's value. The futures offered by the Chicago Mercantile Exchange are based on the S&P/Case-Shiller home price index for each of 10 areas: Chicago, Boston, Las Vegas, Denver, Los Angeles, New York, Miami, San Diego, San Francisco and Washington.

Investors can also buy contracts based on a weighted composite index for all 10 cities.

All futures and options are intended to help protect buyers and sellers from market volatility. For example, a buyer who knows he needs a future supply of a commodity can purchase contracts from a seller to guarantee a set price for it on that date. Housing futures operate similarly to traditional commodities such as oil or wheat, although they do not represent the individual homes. Instead, you're essentially betting on a trend.

In essence, trading futures is a way to "make money on housing without buying the house," Siebel said. Compared with the nothing-down mortgages that were widespread during the boom, he added, "this is less crazy."

Housing futures have drawn interest from "a variety of commercial and non-commercial traders, including housing developers, mortgage lenders, hedge funds and even individual homeowners," said Michael Shore, a spokesman for CME Group, parent company of the Chicago exchange. "Both retail and institutional participants have access to the product. However, for the most part, futures markets tend to attract more institutional investors."

For example, Siebel said, a residential developer who plans to deliver $5 million worth of homes in a year but fears that the value of those homes will decline can hedge against that risk by buying what are called put-option contracts.

A single put-option contract costs $250 multiplied by a premium derived from the Case-Shiller index. In Washington, where November 2009 futures contracts are pegged at an index value of 169.80, the developer would have to buy 120 put-option contracts to cover his $5 million. Generally, an investor puts up 5 percent in cash to buy these options, or a total cost of about $250,000.

The index would have to fall 4.7 percent lower than the current November 2009 futures settlement level for the developer to recoup that investment. (And that 2009 level is already almost 9 percent below the November 2008 level.)

If the index falls more than that, the developer would profit, receiving, for example, $515,000 net profit if values fall by 20 percent.

If the index increases in value, the developer would lose the futures investment, but he would presumably make money on his property sales.

But the expected demand for housing-futures trading has never fully materialized, especially not at the individual-investor level.

So far, housing futures have been interesting only from an academic standpoint, said Matt Hougan, senior editor of the Journal of Indexes, editor of IndexUniverse.com, and a contributing writer for the Exchange-Traded Funds Report and Financial Advisor magazine.

A big part of the problem, according to Siebel: "unfortunate timing."

The product was launched in 2006, near the peak of the market. And as prices continue to feel as though they are in freefall, one might wonder who -- even now -- would be willing to bet against continued declines.

Someone has to be on the other side of your bet that prices will decline, after all.

"The natural buyer is someone who says, 'I think the market is going to go down but not that much,' " Siebel said.

Or it might be someone willing to bet that values will stay flat or even rise -- the sort of long-shot bet that could really pay off handsomely if it proves correct. "Some are priced pretty attractively," Hougan said.

"The idea that prices will fall that much further . . . there are people who will take that bet."

The tiny trading volume also drives up investing costs via large spreads -- the difference between the ask and bid prices. It's a chicken-and-egg issue, Hougan said. "There was a huge amount of excitement when they started," he said, but little follow-through. "We don't see enough activity. People don't want to trade them if there's no liquidity."

Open interest in Merc housing futures was only about 300 contracts on Nov. 14, for example, according to Shore. By comparison, consider that there were more than 300,000 contracts for wheat -- a well-established market -- on the Chicago exchange that same day.

This lack of liquidity makes housing unusual on the futures market. "Unlike most futures contracts, the underlying housing market is not terribly liquid, as it is difficult to quickly buy and sell actual homes," Shore said. "As a result, market makers in housing futures do not enjoy that ready lay-off mechanism." In other words, they can't buy or sell real wheat -- or, in this case, houses -- to cushion losses.

"This leads to wider bid-offer spreads. This in turn means that housing-futures contracts tend to be held for a longer period," Shore said.

Another issue is the extremely localized nature of real estate if you are trying to hedge for a single house. "We don't have a Zip-code-level market," Siebel pointed out. "When you trade the futures, you're trading the metro area," he said. "That's like buying Xerox and selling the S&P 500."

Or like buying Bethesda and selling Manassas.

Still intrigued? Getting started is simple enough. Although futures are usually a professional investor product, "if you want to do this, all you have to do is open up a futures account and fund it," Siebel said.

But housing futures are not a market for the novice, the broke or the faint of heart, finance experts and financial planners say. Home is "a place you live in, not an investment you need to hedge against," said Marjorie Fox, a financial planner in Reston.

Anyone considering investing in housing futures should make sure they fully grasp how they work, Shore said. "Understanding the underlying indexes and the operation of the futures markets are important."

You'll also need a substantial nest egg. Chicago Merc contract positions generally require $40,000 to $75,000 to invest, money that for many people could probably be better saved elsewhere. Bet wrong, and you could lose your entire investment almost instantly. Bet wrong while shorting futures with borrowed money, and you could find yourself auctioning off your real house to pay the bill.

"Futures are a scary market for retail investors," Hougan said. They require large sums of money and high levels of leverage. The potential for huge profits is there, but so is the potential for loss.

Because of that risk, Hougan said he wouldn't suggest housing futures to anyone other than experienced futures traders.

He is intrigued, though, by the housing-linked exchange-traded funds that MacroMarkets has registered with the Securities and Exchange Commission to sell soon. ETFs can be bought and sold like stocks. "It's less leveraged. And you could buy it without registering as a futures trader."

However, he mainly recommends a more traditional method of protecting your equity: "Pay your mortgage, paint your house, and make sure the roof is still shingled."