Although some salespeople would have you believe that home prices never fall, there is in fact a good chance that, after this enormous boom, prices in many places will return to their earlier levels. If homes in Paris or Los Angeles drop back to levels seen just two years ago, that would be a 25 percent drop. Now, it’s true, as the salespeople love to point out, that there seems to be no record of large drops in nominal home prices in major cities for the last 50 years, with the exception of a few places like Japan or Germany. But the last half century has also not seen another boom of the magnitude we have just witnessed.
Of course, we do not know with any certainty how far, or even whether, home prices will fall. Despite a lot of talk about imminent collapse, the evidence is mixed. Speculative booms have an uncanny history of outlasting all the experts’ expectations. Indeed, the end of the housing booms in London and Sydney was proclaimed a couple of years ago, when these markets did start to decline, but now prices there are showing strength again. Still, housing prices are weakening from New York to San Francisco, in a market that has lacked a basic financial tool for managing periods of high uncertainty and risk.
My colleagues and I have been campaigning for years to create a home-futures market, much like the futures that help manage risk in stocks and bonds, soybeans and pork bellies. It’s been frustrating. Despite the boom in exotic futures known as derivatives, creating comparatively simple home futures has been hard. We now think the biggest obstacle was the credibility of home-price indexes, which at times registered implausibly large swings.
This May the Chicago Mercantile Exchange created home-price-futures markets for 10 U.S. cities, from Boston to Miami and Chicago to San Diego, plus a composite market. These markets use indexes that Karl Case and I worked 20 years to create, recently in cooperation with Standard & Poor’s and Fisery Inc. While there have been betting sites for home prices, this is the first real home-futures market since one attempt failed at the London Futures and Options Exchange in 1991. Although the volumes are still small, with about $90 million in contracts outstanding, the markets are already establishing a pattern. They have been predicting drops in home prices for all 10 cities in the 5 to 9 percent range by next August.
The markets work like this: a homeowner or anyone who feels overexposed to local home-price risk can sell futures contracts for that city. If the price index drops, the payment from the futures contract will cancel out some or all of the owner’s loss on the home. Dealing with risk in this way is known as hedging. Conversely, anyone who feels underexposed to home prices can buy in the futures market. This contract will pay if home prices go up, and represents an investment without the hassle of buying and managing property.
That’s all there is to it. Homeowners don’t want to sell their homes but want to reduce risk. Investors don’t want the nuisance of buying actual homes but want to participate in the upside of the market. In effect, anyone in the world who wants to invest in U.S. homes can do so indirectly by buying futures from someone in the United States who wants to hedge. In practice, most of the investors are likely to be professionals, and their presence will likely mean that this market will do a better job of predicting prices than the cheap talk of individual forecasters.
In the past, few foreign investors would have invested in U.S. homes. Even the biggest professional manager of single-family housing in the United States, Redbrick Partners, owns and rents out only about 1,000 homes, and even these are often blocks of town houses. The CEO of Redbrick Partners, Thomas Skinner, told me that it is just too hard to manage dispersed properties. A lot of single-family homes are owned by investors, but these are almost always mom-and-pop operations, with the owners on the scene, watching everything.
All that will be changed by the new markets. Investors in Tokyo or Rio can invest in U.S. homes without coming to the United States or speaking a word of English. Futures will allow firms to offer retail risk-management services to people who find these markets intimidating.
Armed with the futures markets, financial exchanges or investment bankers can create financial products whose values track the indexes. For example, they can create home-equity insurance that protects homeowners against drops in the value of the homes in their city. Or they can create innovative mortgage products that protect the value of the down payment on a home against loss due to falling home prices in the city. Already in the United States, the investment bank Goldman Sachs has announced that it is creating home-price risk-management products based on the same indexes that are traded at the CME.
Will these products grow large enough to tame the effects of the swings in home prices? There is reason to think so. In the U.K., analogous financial-derivative products based on commercial real estate, rather than individual homes, have appeared in the last couple of years, and the markets are now rapidly growing. According to the Financial Times, the number of such derivatives as of last month reached 157 deals, with total value now surpassing £1.9 billion. The typical such deal is a swap, whereby institutions agree to exchange real-estate value, as measured by one of the International Property Database indexes of commercial real-estate value, for a more stable cash flow such as a fixed-interest payment.
If derivative products can work based on commercial-real-estate price indexes, then they ought to work based on home-price indexes as well. It may still take years before all these risk-management products are really prominent in our lives, but that time is coming. When that happens, we can expect to see a more rational global real-estate market, with fewer speculative bubbles, a tamer business cycle and a more stable environment for all of us to plan our lives.
