Capitalism 2.0: US Real Estate Derivatives

As we begin the second week of the CME's housing futures and options market trading (real-time quotes for futures are here), anyone who has been watching this market debut is immediately struck by the lack of liquidity. In the first week of trading there was effectively no volume. Of course, new market products like this take time to develop, but questions remain about the viability of the concept of a residential real estate derivatives market.

Some comments from the Tuesday, May 30, 2006 (US ed.) Financial Times...

From the Lex Column:

Most homeowners try to protect their properties with insurance. That makes the real-estate derivatives finally launched last week by the Chicago Mercantile Exchange all the more enticing. The US housing market is looking increasingly vulnerable. From individual homeowners, developers and construction companies to mortgage issuers and government agencies, it is easy to think of parties keen to offload the risk of a collapse.

What is less clear is whom they would trade with. In principle, institutional investors should be keen to get exposure to residential housing. Real estate is a huge asset class, under-represented in most of their portfolios. Studies in the US, and elsewhere, suggest that house prices tend to have a low or negative correlation with bonds and equities. The same, says the CME, has even been true for Real Estate Investment Trusts for much of the past decade.

But, in spite of the benefits of spreading risk, there are several factors that could deter investors in the near term.

Most obviously, any housing crash would have serious repercussions for other asset classes. Moreover, the very transaction costs that make cash-settled futures attractive also prevent arbitrage. As a result, the futures may well decouple from the underlying indices. After all, home prices generally tend to be sticky when fundamentals suggest a decline and, while the indices used avoid many of the methodological problems of rival measures, they will still lag behind actual prices.

All this suggests that it could take years for housing futures to become useful risk management and forecasting tools, even if they attract sufficient liquidity. Based on the first week of trading, that remains a big "if", and looks likely to limit their usefulness in the current cycle.

These concerns echo the many discussions we have had about this market. The proposition remains fundamentally sound: create a market for products which rely upon the negative correlation (or non-correlation) between residential real estate and bond/stock markets. The problem is that this proves to be very difficult to accomplish in practice.