Housing hedge

New housing futures may offer protection for home equity.

Have you ever wondered why it is that Chancellor Bismarck of Germany is so revered in corporate human resource departments the world over? OK, maybe not. I'll tell you anyway; by taking advantage of the IT advances of his day–cheap paper, typewriters, carbon paper and reliable filing systems–he created the world's first pension plan, back in 1889. All of a sudden it was possible for German civil servants to collect payments from citizens through their working years, and then make payouts in old age, based on work history. The pension promise became a standard part of western life, and a whole new era of individual economic stability opened up.

And it lasted–for a while. Today, it seems the pension promise is again moving beyond our grasp. Defined-benefit corporate pensions are being phased out and replaced by defined-contribution plans (transferring the risk of running out of money in retirement from employer to employee). Those same corporate pension plans are massively underfunded, while life expectancy continues to extend, putting yet more strain on plans to provide more benefits. The blessed state of economic security that was supposed to kick in after age 65 seems further away today than it was for a 19th-century German peasant.

Is there any hope for a more stable future? Minimizing the big economic shocks we encounter through life is an issue Robert Shiller explored in a book published back in 2003 called The New Financial Order. Shiller, you may remember, was the author of the 2000 classic Irrational Exuberance, which called the peak of the tech bubble. His followup didn't do as well, but maybe it should have. After all, it sets out a blueprint for how humans might come to manage and master the largest risks in life, such as a failed career or a decline in national GDP.

It's a fascinating read, for a book about finance, anyway. It proposes the creation of livelihood insurance (to cover the career disaster part) and inequality insurance based on securities linked to national GDP. Shiller, however, is apparently a practical man: he helped create a company, called MacroMarkets LLC, which has been developing some of the markets described in his book. “It's a pretty lofty mission statement,” admits Terry Loebs, managing director at the New Jersey company. “Create financial instruments to allow people to gain exposure or hedge exposures to asset classes and economic interests that heretofore have been difficult to access.”

Business is good, however. In May, a housing futures contract started trading on the Chicago Mercantile Exchange (CME) that will help implement one of the ideas in The New Financial Order: home-equity insurance. We cover fire–why not cover a decline in economic value? It is, after all, one of the largest risks most homeowners face, especially if you consider the role home equity plays in the average family's total wealth portfolio. Key to providing such a product is having a security against which you can hedge the value of housing. And key to that security instrument is a housing-price index, which is where the Case-Shiller index comes in. In the late '80s, Shiller began collecting information on home prices, which he combined into an index that has since come to be recognized as a leading source on housing prices. “Over the last decade, it's become the most reliable means of tracking home prices in the U.S.,” says Loebs. “It's the gold standard in housing-price measurement.”

It's also serving as the settlement vehicle for the new CME futures, which have found an audience among the country's large consumer lenders, mortgage lenders and mortgage insurance companies. “A lot of people have a lot of long real estate exposure these days,” says Loebs. “Given the recent discussion and debate over the prospect of regional housing bubbles, the spectre of an overhang has generated strong interest in the product.”

No kidding. A year ago, Commerzbank released a major report suggesting there was a housing bubble in the States. Since then, the worry has only grown. Shiller himself has said the bubble in housing is the biggest since the late 1800s. Thank goodness, then, for the new housing futures. Contracts are offered on housing in 10 different cities–Chicago, Boston, Las Vegas, Denver, Los Angeles, New York, Miami, San Diego, San Francisco and Washington, or as a weighted composite index of all, and settled quarterly.

Of course, a U.S. housing future might not seem worth much to most Canadians. You could use it as a speculative tool to bet on the direction of the U.S. housing market, although you'll need some money to do that–the CME contracts generally run between US$40,000 to US$60,000 (although Denver is a bargain at US$34,000). But what is expected to happen is that the introduction of this new asset class will change the housing market itself. Long-term prices will likely be more stable, while materials suppliers and contractors will be able to operate more efficiently, since they'll be able to hedge their risks. A homebuilder putting up a large subdivision, for instance, will be able to hedge the risk home that prices might fall before finishing the project.

Eventually, a home-equity insurance product could be introduced by one of the companies currently getting used to the new futures contracts (which, hopefully will one day migrate to Canada). According to Loebs, home-equity insurance is just the first step: “Our primary push is residential housing. We figured we would start with that, conquer that and see where we go from there.”

Just as cheap paper and typewriters allowed aged Germans to retire way back when, the computing power of today may allow us to hedge new classes of risk. Who knows? Maybe we might even be able to take some of the worry out of retirement.