Global Investing: A New Hedge For Your House

If all the jabbering about a weakening housing market has made you glum at the prospect of your own home's losing value, then has the Chicago Mercantile Exchange got a portfolio addition for you. Since May, investors have been able to buy and trade options and futures contracts pegged to home prices in 10 U.S. cities, giving property owners a way to hedge against a bear market--and letting speculators place bets on the direction of house prices in San Francisco, New York City, Chicago, Las Vegas and elsewhere.

Think of a guy who is anxious that his hacienda in Miami might be caught in a bubble but doesn't want to cash out and move. If he buys a put option on the Miami housing-price index and the value of homes in Miami (including his) slides, the money he makes on the derivative offsets his loss. A put option is the right, but not the obligation, to sell a security at a set price. A futures contract is an agreement to buy or sell something at a future date. Both are derivatives because they derive their value from an underlying asset, in this case, real estate. If that sounds complicated, well, it is. The notional value of the futures contract is about $50,000 and is bought on margin with just a few percent down, which means you can get badly burned. Since the May debut, developers and hedge funds are among the big buyers.

If the market for housing futures gets large enough, though, other sorts of financial products more useful to homeowners should crop up, says Robert Shiller, a Yale University economist who has been pushing the idea for 15 years. The grander vision, developed with Karl Case of Wellesley College, includes home-equity insurance. The idea is that companies will write those policies if there's a robust futures market for hedging risk. "Real estate is bigger than the stock market," says Shiller. Twenty trillion dollars big, in fact.

There have, however, been a couple of notable nonstarters. The London Futures and Options Exchange halted its property futures in 1991 four months into trading, after a scandal erupted over dummy trades. In 1993 the Chicago Board of Trade, with help from Shiller and Case, readied its own foray but then pulled the plug prelaunch. The nature of houses is an impediment, says Craig Pirrong, professor of finance at the University of Houston, because speculators crave volatility and home prices change slowly--and even within one city, there can be vast differences in values.

Trading volume at the Chicago Merc has been thin so far, with interest in Miami, New York City and Los Angeles far eclipsing Denver, Chicago and Boston. But a slow start is often the case with derivatives. Shiller, who helped design the housing-price indexes the Merc contracts are based on, points to S&P 500 futures, which were half-heartedly received in 1982 but today are a Merc staple. For housing futures, the exchange is already looking to add more cities and contracts past 2007; homebuilders who want to hedge new subdivisions have requested the longer horizon. The Chicago Board Options Exchange is considering housing derivatives too.