Why Aren't Housing Derivatives More Popular?

That was the main topic of conversation at a conference on real estate derivatives that took place in New York over the past three days. I headed down yesterday to hear Yale economist Robert Shiller of Case-Shiller and Irrational Exuberance fame talk about why the products are not catching on.

But before I get to that, let's look at how useful real estate derivatives would've been in protecting someone against the drop in home prices during the current downturn. I'll use Miami futures contracts as an example.

According to the Case-Shiller index, home prices in Miami are off 25 percent since their peak in May 2006, which is also when the Chicago Mercantile Exchange started trading real estate derivatives. The Miami index was at 278.68 back then. Let's assume that's what the May 2008 contract was selling for. Now the May 2008 contract has dropped to 210.20. So if you sold short one contract in May 2006, and closed out your position today, you'd be up $17,100.

Now, if you owned a home that was valued at $500,000 two years ago, it'd be selling for about $375,000 today, so in order to fully hedge against that loss you'd have had to sell seven contracts short. But that's obviously easier said than done, so let's find out why more people didn't do this. Shiller thinks there are three factors involved:

1) Bad Timing and Behavioral Finance
With the sorry state of the housing market, people are acting as behavioral economics would predict: avoiding the fact that they've lost money.

2) Owning a Home Is Already a Hedge
Economists Todd Sinai and Nicholas Souleles argued that point in this 2003 paper. They claimed that people buy houses to protect themselves against rent risk. Shiller says this might be a factor, but also countered that home costs take up a greater portion of consumption than rental costs, so it's not much of a hedge.

3) Not-Ready for Prime-time
A combination of the fact that the industry hasn't been able to educate the public yet on the benefits of hedging against real estate value loss and a lack of consensus on which index is best have all slowed the adoption of real estate derivatives by both institutional and retail investors. (Ironically, Shiller spent the majority of his talk ripping into a competing index by Radar Logic.)

Out of the three factors, Shiller said by far the biggest problem was the latter, and that it was primarily up to the industry itself to remedy the situation.

"If you look at people's portfolios, it's really a tragedy in this country today that the median household has most of its wealth in single family homes," he said. "We have a very bad portfolio management situation and we need institutions that will get them out of this situation."