For most Americans, the most important asset class is not the stock portfolio, it's the house. No wonder some homeowners are getting a bit nervous. The sub-prime mortgage fiasco is forcing up the cost of money, particularly on jumbo mortgages, which are important loans in metropolitan areas where middle-class houses cost $500,000 (and even more). The rise in mortgage rates will almost certainly put downward pressure on housing prices in areas such as New York City and its suburbs, which have remained hot even as other markets have cooled. (The National Association of Realtors recently lowered its forecast for existing homes nationwide, and forecasted the average price will slip by a little over 1 percent in 2007, but rise in 2008.)

Put another way, your clients who own homes may feel poorer at the moment. And who could blame them? Residential real estate represents more than a third of the total value of domestic assets, according to the Chicago Mercantile Exchange. By the end of 2005, real estate — valued at $21.6 trillion — became the second largest asset class behind fixed income investments. Traditionally, the residential real estate market has been an asset class that you couldn't hedge very well (except by shorting, say, Toll Brothers).

The Good News

But now you can. A year ago, a suite of cash-settled futures contracts based on S&P/Case-Shiller housing indexes were launched on the Chicago Mercantile Exchange. The Merc contracts track 10 metropolitan markets — Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco and Washington, D.C. (as well as a U.S. composite). The benchmarks were developed by economists Robert Shiller, of Yale University and Karl Case, of Wellesley College. According to their founders, these benchmarks have become the most accurate measures of the nation's residential real estate markets.

Shiller should know something about markets. His book, Irrational Exuberance (Princeton University Press), first published in 2000, correctly forecasted the dot-com explosion. Savvy investors who bought the book when it first came out (the stock market started to tank one month after it was published) could have heeded Shiller's call, and either liquidated their holdings or hedged their exposure before tech stocks bottomed out. Of course, these lucky investors had tools to lay off their risk. Stock and bond portfolio sales have long been hedged or simulated through the use of stock indices, or bond futures, options and exchange-traded funds (ETFs).

Before the advent of housing futures, however, safeguarding residential real estate wealth was left to imperfect hedges that could actually increase, rather than decrease, risk. Real estate investment trusts, for example, track bond and equity prices more closely than home values (see “Long Term Correlations,”page 108).

The Not-So-Good News

The inefficiency of cross hedging can be eliminated with housing futures. Using them effectively requires investors and advisors to exercise the same care employed when using stock index futures to hedge an equity portfolio.

First of all, there is basis risk to consider. Here, basis risk represents the tracking error between a contract's underlying index, and the value of a given home. Keep in mind that the markets represented by futures are regional: They include the target city and its environs. A beta of sorts has to be derived to adjust for the idiosyncrasies of a client's particular market. Manhattan's Upper East Side, and the Flatbush section of Brooklyn, are both subsumed within the S&P/Case-Shiller New York Metro Index, but each is subject to vastly different pricing pressures.

Likewise, areas outside a metro region will be subject to unique price dynamics. For instance, housing prices in California's Napa Valley Wine Country are 1.53 times as volatile as those in San Francisco, some 50 miles to the south, according to research from National City Corp. A housing futures contract is priced at $250 times the underlying index. If, for example, the San Francisco Metro Index is now at 211, the value of a contract based upon the Bay Area index would be $52,750. Thus, to fully hedge the median-priced ($791,900) San Francisco home against a price decline, 15 contracts should be sold. To fully hedge a median-priced ($532,600) Wine Country home, 16 San Francisco contracts ($532,600 ÷ $52,750 contract value × 1.53 beta) would have to be shorted.

To see the degree of protection afforded, let's suppose a Wine Country client intends to sell his home within, say, nine months. Fearful of an intervening decline, he could hedge to produce the results shown in “Hedging Against Declining Home Prices,” below. In this “perfect hedge,” the entire price risk is mitigated, and a little “extra” is earned to boot as the result of a favorable change in the basis.

The not-so-good news is that this “insurance” cover is expensive. The initial margin requirement for the San Francisco housing contract is presently $2,025, meaning a total of $32,400 in cash or T-Bills must be deposited to open the position — that's nearly the amount of risk being hedged. Even though this transaction is used to reduce the client's overall risk, reduced or hedge margin rates aren't available to non-commercial accounts. True, margin requirements are only good faith deposits, but they still tie up capital.

And what if, unexpectedly, real estate values bottom out or even rise while a hedge is in place? Our Wine Country client depositing just the exchange-mandated minimum opening requirement will face a margin call if futures settle just 2.20 index points above his 211 selling price. More cash would then be required to support the position. An example of a hedge turned unnecessary is illustrated in “A Hedge Too Far,” on page 110.

It's important to appreciate the difference in cash flows while hedging. The home's value is only realized upon its sale — a transaction that's months away when the hedge is initially placed. The complementary futures position, however, is marked to market daily: Losses are realized as they occur. The $40,000 setback illustrated in “A Hedge Too Far,” is actual cash out of pocket, offset (partially) only when the home is sold. This illustrates the need to constantly monitor market conditions to determine if a continuing hedge is necessary. If not, the hedge can be lifted before margin calls eat into the client's capital.

Prudent For The Retail Set?

With this in mind, it's wise to ask if hedging ought to even be attempted by individuals. “I don't know if a homeowner should hedge her housing values,” says Fritz Siebel, director of property derivatives at New York's Tradition Financial Services, “but a homeowner now can. The ability to transact listed futures and options using S&P/Case-Shiller indexes allows the market to transfer single-family home value risk to, and away from them.”

For Pete Thomas, a senior broker at R.J. O'Brien in Chicago, the hedging of home values is a very personal decision. “It truly depends upon the client and how long he or she plans to live in the house,” says Thomas. Hedging might be more appropriate for someone with a job-related relocation looming in the next few months, someone obliged to reposition assets as part of an estate planning maneuver, or someone who “flips” houses in a soft market.

Indeed, most investors who don't foresee a forced sale in their futures may be inclined just to wait out the current down cycle. Despite all the hoopla about a wholesale price collapse, home values rarely plummet overnight. Take a look at the San Francisco housing market. According to economists at National City Corp., the median price for a single-family San Francisco residence — $791,900 in 2007's first quarter — represents an overvaluation of 23.4 percent. Over the past two decades of price corrections, say the dismal scientists, the median degree of overvaluation prior to a correction is 35 percent. That doesn't mean prices drop 35 percent after peaking, though. In fact, the median price correction is 16 percent over 16 quarters: The more severe the overvaluation, the greater the subsequent decline and the shorter its duration. On the whole, price declines are about half the initial degree of overvaluation. One thing to keep in mind: The standard deviation of housing valuations is plus or minus 13 percent, so overvaluations (or undervaluations) are within a “normal” statistical range.

In a benchmark example from the National City database, San Francisco home prices declined 10 percent — over 19 quarters between 1990 and 1994 — after peaking at an overvaluation of 25.3 percent.

The table titled “Current Performance,” on page 111, traces the arc of the S&P/Case-Shiller San Francisco Metro Index compared to other asset classes over the past three-and-a-half years. Housing prices hardly seem ready to make an Acapulco cliff dive when compared to the heights attained by REITs or a homebuilder stock like Toll Brother (TOL).

Still, a down cycle is a down cycle. For clients with large residential real-estate exposure, hedging just the overvaluation, or speculative, element can provide a modicum of protection without neutralizing upside potential entirely.

Let's go back to our Wine Country homeowner. National City economists define the current degree of overvaluation in Napa, Calif., at 42.3 percent. That puts $225,290 (42.3.9 percent × $532,600) of the client's home value “at risk.” With a San Francisco housing index contract priced at 211 and a beta of 1.53, seven contracts could be sold short as insurance. Keeping in mind the history of price declines amounting to only half the degree of overvaluation, the client could self-insure further by hedging with only four contracts.

The trouble with futures is that they're short-lived. At present, the furthest expiration available is May 2008. A long-term hedge then would require “rolling” futures forward to later expirations as they're listed. Unfortunately, there's a cost to this. Not only brokerage fees, mind you, but a built-in loss owing to the market's embedded expectations.

As of this writing, there are four San Francisco housing futures deliveries: August 2007 at 211.00 index points, November 2007 at 207.60, February 2007 at 207.20 and May 2008 at 203.40.

According to Tradition's Fritz Siebel, this price slippage (known as “backwardation” in industry jargon) is typical of a market without “carrying” charges. “You can't deliver physical assets through these contracts. The futures curve is lower further out because that is where the market sees the indexes going.”

To roll a short hedge forward, expiring contracts must be bought back while new short sales are established in distant contracts. That said, current market conditions force short hedgers to pay up when buying back near-term contracts while they sell deferred contracts at lower prices. Siebel says the quarterly roll cost has averaged 1.5 percent in the past year.

This is particularly worrisome to Lew Altfest, CEO of New York investment advisor L.J. Altfest & Co. Altfest wonders if the housing market isn't setting itself up for long-term stagflation. “If the market stays flat for the next five years with annual inflation running at 3 percent, there's a 15 percent loss there,” he cautions. Rolling a futures hedge forward for five years could “eat you alive,” he says.

Worse still is this: even if a hedge is deemed necessary, many clients don't have access to these instruments. They are, after all, futures contracts. Without a futures account and an appropriately registered (Series 3) executing broker, these derivatives are verboten.

That leaves securities-based hedges for the hoi polloi. “Shorting REITs would be a very ineffective hedge,” says Altfest. “Collectively, REITs reflect both the housing and commercial real estate markets. And now REITs are more likely to behave like stocks than real estate.” (See “Current Performance.”)

“Shorting a homebuilder stock such as Toll Brothers may not be such a bad idea,” adds Alfest, “but prices have already fallen” (Again, see “Current Performance”). Altfest worries that the declines already priced into these stocks leave little room for further hedge protection.

Are home prices set to plummet further? Real estate values, too, are often subject to the vagaries of emotion. Judicious hedging, however, can protect those clients with access to the futures market, keeping them from turning, well, chicken.

CURRENT (OCT 2003 - MAY 2007) CORRELATIONS


SF Housing Bonds Stocks REITs
SF Housing - - - -
Bonds -0.119 - - -
Stocks -0.198 -0.027 - -
REITs -0.121 -0.050 -0.032 -
Toll Bros. 0.125 0.255 0.263 0.233
SF Housing = S&P/Case-Shiller San Francisco Metro Housing Index
Bonds = Lehman Aggregate Bond Index
Stocks = Russell 3000 Index
REITs = Dow Jones US Real Estate Index
Toll Bros. = Toll Brothers (TOL) Common Stock Price
Source: Brad Zigler

LONG-TERM CORRELATIONS

Before the advent of housing futures it was difficult to hedge residential real estate. Real estate investment trusts, for example, track bond and equity prices more closely than home values.


Housing Bonds Stocks
Housing - - -
Bonds -0.169 - -
Stocks -0.390 0.052 -
REITs -0.074 0.177 0.153
Source: Chicago Mercantile Exchange

HEDGING AGAINST DECLINING HOME PRICES


(Long) Home Value (Short) Futures Notional Value (Long) Basis
Hedge Placed
(Sell Short 16 Contracts)
$533.000 (Index @ 211.00)
$844,000
-$311,000
Hedge Lifted
(Cover 16 Contracts)
$287,000
$485,000 (Index @ 195.00)
$780,000
-295,000
Net -$48,000 +$64,000 +$16,000
Source: Brad Zigler

A HEDGE TOO FAR?


(Long) Home Value (Short) Futures Notional Value (Long) Basis
Hedge Placed
(Sell Short 16 Contracts)
$533.000 (Index @ 211.00)
$844,000
-$311,000
Hedge Lifted
(Cover 16 Contracts)
$549,000 (Index @ 195.00)
$884,000
-$335,000
Net +$16,000 -$40,000 -$24,000
Source: Brad Zigler