Friday, October 2, 2009

Housing derivatives: Pie in the sky?

Posted on Rortybomb:

Robert Shiller writes in defense of financial innovation, and James Kwak, Ryan Avent and Felix Salmon artfully take it apart.

My interest is in Shiller’s use of housing derivatives. Here’s Felix:

Shiller simply takes it on faith, however, that a nice liquid market can and should spring up to provide two-way prices in such risks, solving lots of problems at a stroke; he doesn’t stop to consider that maybe the reason such markets haven’t sprung up is precisely that there’s no real demand from anybody wanting to take on those risks. In reality, Shiller should know that better than anyone: his much-vaunted house-price derivatives have gone nowhere, partly because no one ever really had any need or desire to go long.

Shiller’s first proposed innovation is an attempt to deal with the regrettable move, in recent years, towards a “popular reliance on housing as an investment”. Only except for suggesting the obvious — moving people away from the idea of housing as an investment, and towards good old-fashioned renting — he comes up with a complex mortgage with all manner of embedded options. As with any derivative, those options will be a zero-sum game, and you can be sure the homeowner is going to end up on the wrong side of it. But Shiller still seems to think it’s a good idea for homeowners to buy them, instead of simply getting a plain-vanilla, easily-comprehensible mortgage, with payments which are set over the life of the loan and which are entirely predictable.

Shiller has been talking about this for a while, and I still don’t get it. There’s a lot of talk about derivatives as some sort of magic, but all they are is a secondary bet on the price of something, called an underlying. Their value is derived from something else. And one of the fundamental things about options is that you need to be able to buy or sell the underlying if you are able to effectively handle the risk of derivatives. One of the fundamental insights of Black-Scholes that a derivative isn’t made of magic, it is just made with a position in the underlying and a position in cash.

Like oil. If the futures market spins out of control, you can always just buy the oil itself, store it, and deliver it in the future for the futures contract. That’s why there was all the drama with demand for oil tankers over the past year – people were hoping to buy the commodity now at the spot price and deliver it to futures customers. If these prices differ too much in equilibrium, we back out a “cost of carry” or a convenience yield. The prices are different because it costs some money to store that oil for the future, or because it is helpful to have in your pocket to deal with short-term fluctuations, etc.

How is this supposed to work with housing? What’s the “cost of carry” on a unit of housing in Los Angeles? Taxes, repairs, maintenance, insurance, etc. all add up really quick. What’s the transaction costs in quickly buying and selling a unit of the underlying? Brokers fees add up even faster. The fact that quickly buying and then dumping $1m in the underlying is very costly and takes a large amount of time – unlike oil – makes me think that there’s no way for this to ever take off as a real derivative market.

I have a lot of quant and options-smart readers, so someone explain to me how one is supposed to handle this? Is it even possible to go short, delta-hedge, or carry housing risk at a hedge fund? If not, why are we putting any hope in this market getting some real juice in it?


  1. I don't think it works very well until you have a liquid market. Otherwise the bid/ask spread is too far apart and the hedging is too expensive. These derivatives are effectively insurance policies and therefore have a time component to them which eats up a lot of your cash flow over time.

    Have you heard of any strategies for commercial real estate? I saw this article which relates to the CRE world...
    Hedging Commercial Real Estate Risk

  2. I don't follow CRE that closely because it's only "big boys" that play in that market. However, I've seen signs of a fairly active market in the UK.


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