Saturday, July 08, 2006

A financial hedge for your house

After proving itself with Weather Futures, the Chicago Merc launched another important innovative product, Housing Futures and Options, earlier this year. These are financial contracts which allow residential home owners to hedge their long real estate exposure against declines in value by taking a short position in one of the housing contracts. The largest market participants currently are foreign and domestic institutional investors and should eventually include speculators as bid-ask spreads shrink and more options contracts become available. The housing contracts are currently offered for the top ten markets in the US as well as in composite.

The housing contracts are pegged to a set of broad-based US nationwide residential real estate indices, the S&P/Case-Shiller Indices, an important instrument which registers the changes in regional home values in a standardized way. The Indices were developed by Wellesley economist Karl E. Case and Yale economist Robert J. Shiller who discussed the idea for housing futures and other finance innovations in his 2000 book, Irrational Exuberance. Here is a graph of data from the S&P/Case-Shiller indices, showing the general run-up in all residential housing in the last twenty years with San Francisco's Internet bubble sticking up and both San Francisco and New York lagging the national composite in the last two years.

The aggregate value of US residential real estate is approximately $20 Trillion (assuming 75% of total consumer debt is mortgage debt and aggregate loan-to-value is 45%) meaning that it is one of the largest asset classes which has previously not had highly liquid widely tradable standardized financial instruments. Putting the size of the real estate asset class in context, the 2005 US GDP was 12 Trillion, the total US stock market capitalization is $13 Trillion, and the US bond market size is $26 Trillion.

Hopefully there will be an acceleration of new financial instruments from trading exchanges like the Merc and the CBOE and startups like derivatives innovator Hedge Street and consumer loan community Prosper.