Does Hedging Make You A Chicken?

[Editor's note: This article originally appeared in the September 2007 issue of Registered Rep. magazine.]

Chicken Little's notion that the sky was falling once convinced a whole barnyard full of animals to avoid the woods. In the same way, pundits' forecasts of a bursting housing bubble have many clients fretting about a serious diminution in their wealth.

Unlike Chicken Little's friends, these clients may have real reason to worry. Residential real estate represents more than a third of the total value in domestic asset classes according to the Chicago Mercantile Exchange. By the end of 2005, in fact, housing values -- at $21.6 trillion -- became the second-largest asset class behind fixed income investments (see Figure 1). Despite the size of this risk, there has been no effective way to hedge housing exposure until recently. Therein lies a "good news, bad news" story.

Figure 1

The good news

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 ten 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 and have become, at least according to their founders, the most accurate measures of the nation's residential real estate markets.

Shiller should know something about markets. His book Irrational Exurberance forecast the dot-bomb explosion. Savvy investors who bought the book early 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 been long been hedged or simulated through the use of stock index or bond futures, options and exchange-traded funds.

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 Figure 2).

Figure 2

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's 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. Data from National City Corp.'s economics unit, for example, indicates that housing prices in California's Napa Valley Wine Country are 1.53 times as volatile as those in San Francisco, some fifty miles to the south.

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 x 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 Figure 3.

Figure 3

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 the 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 would 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 Figure 4.

Figure 4

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 Figure 4 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. The hedge could have been lifted before margin calls ate into the client's capital.

With this in mind, it's well to ask if hedging ought to be even attempted by individuals. "I don’t know if a homeowner 'should' hedge their housing values," opines 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 estate planning maneuver, or someone who "flips" houses in a soft market.

The not-so-bad news (for some)

Indeed, most investors who don't foresee a forced sale in their future may be inclined to just wait out the current downcycle. 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 ±13 percent, so overvaluations of 13 percent 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.

Figure 5 traces the arc of the S&P/Case-Shiller San Francisco Metro Index compared to other asset classes over the past 3 1/2 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 Brothers (TOL).

Still, a downcycle is a downcycle. 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 divined the degree of over valuation in Napa, California at 42.3 percent presently. That puts $225,290 (42.3% x $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 bad news

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.

Figure 5

As of this writing, there are four San Francisco housing futures "deliveries:"

Aug-07 at 211.00 index points, Nov-07 at 207.60, Feb-07 at 207.20, and May-08 at 203.40.

According to Tradition's Fritz Siebel, this apparent backwardation is characteristic of a market without "carrying" charges. "You can't deliver physical assets through these contracts," says Siebel. "The futures curve is lower out forward 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 three percent, there's a 15 percent loss there," he cautions.

Rolling a futures hedge forward for five years could "eat you alive" according to Altfest.

The really bad news

Worst 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 more like stocks than real estate." (See Figure 5)

"Shorting a homebuilder stock such as Toll Brothers may not be such a bad idea," adds Alfest, "but prices have already fallen" (Again, see Figure 5). Altfest worries that the declines already priced into these stocks leave little room for further hedge protection.

Is the sky falling?

Chicken Little's lack of experience with falling acorns convinced her that the sky was falling. Her resulting hysteria proved infectious. 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.

Comments

[Jonathan Reiss:]

Excellent article except for some of the "bad news" and "really bad news". The 'bad news" is that you can't trade futures longer than 1 year. This is true TODAY but next week (Sept. 17th to be exact) 5-year futures will start trading.

The "really bad news": he says that a major drawback is that the hedge uses futures contracts and so you need a futures account to trade them. While futures are unfamiliar to many people, and are not right for everyone, opening a futures account is not a lot harder than opening an account to trade stocks. There are brokers listed on the CME housing web site www.cme.com/trading/pr... and also mentioned in the article who are quite familiar with trading housing futures.

Jonathan Reiss
Analytical Synthesis
market-maker in housing futures

2007 Sep 11 01:26 PM

[Uncle Bill:]

Yes, an interesting article. But you should hedge with options rather than futures. Selling call options takes away the need to buy your hedge back before it expires. Also, time works in your favor. If the house price remained the same, you would make money from selling premium. A true hedge reliquishes some upside return. Not enough hedge? Sell the call and buy the put, at the money. The put will cost a little more than the call, but you'll be protected from that big hit. It's a lot cheaper than your futures hedge. CME offers options on the Case/Shiller futures. That should have been your story. Nobody hedges a long stock position with futures. Why should you do it with your home? impliedrisk.blogspot.c...

2007 Sep 11 02:28 PM

[Brad Zigler:]

Yes, options are indeed offered on CME's housing futures.

Unfortunately, they're more illiquid than the underlying contracts.
In August 2007, 193 housing futures contracts were traded. And the options? Over the 23 trading days in August, only ONE housing option contract changed hands. One can't very well get off an effective hedge when market makers have to build in big edges to cover their risk.

More important, however, option hedges present different risk/reward dynamics compared to futures. To say that "selling call options takes away the need to buy your hedge back before it expires" is misleading. If you're the only guy holding a short in-the-money call, you're gonna get assigned unless you cover.

Shorting a call, too, offers limited hedge protection versus selling futures. You can, at best, earn the option's premium and no more, in a declining market. Futures, at least, offer open-ended gains.

The loss potential for a call option in a rising market, too, is open-ended just like that of short futures, save for the mitigation provided by the premium.

Yes, in a stable market, the call's time premium can be earned. But we're talking about housing price protection here: taking out insurance just as a wheat farmer hedges part of a crop to salvage production costs.

Financing a put purchase with a call sale creates a synthetic short futures position with risk/reward parameters similar to a "natural" futures trade.

Given the illiquidity of the option market, however, it may be difficultt to get off such a "collar" at a favorable net premium. Heck, it might be difficult to get it off at all.

To say that nobody hedges a long stock position with futures ignores reality. Aside from institutional use of "large" contracts, retail customers have made mini-futures on the S&P 500 and the Nasdaq-100 indexes the most active contracts in the domestic market.

2007 Sep 14 12:43 PM

[Brad Zigler:]

Thanks for the update. When this article was originally written, long-dated futures were just a gleam in the eye of the exchange and the licensor.

Five-year futures make a whole lot of sense, especially if the real estate slump prove intractable.

While finding a Series 3 broker is made a lot easier with the CME tool, some individuals may balk at having to establish a de novo account for any number of reasons.

First of all, there's the issue of margin. All futures trades are leveraged. Some accounts can't countenance margin trades, whether they're in a securities or a commodities account.

Then there's the inconvenience of establishing a new account relationship. Whether customer can find an in-house Series 3 broker, or a new brokerage sought, a commodity account must still be established. That's, rightly or wrongly, a natural barrier for some potential users.

2007 Sep 14 12:10 PM