CME to launch housing index futures in the first half of 2006: exchange officials expect great response but not everyone in the industry is so optimistic.
The Chicago Mercantile Exchange (NYSE, NASDAQ: CME), the world’s largest financial exchange, has announced its plans to list housing futures and options, based on the Case-Shiller Indexes® (CSIs) of home prices, in the second quarter of the next year.
The details have been made available in the last two weeks, following the signing of a licensing agreement in late September with MACRO Securities Research, LLC, the New Jersey-based financial research firm which is in charge of developing these contracts.
The idea of creating an index-tracking vehicle that would allow market participants to gain full exposure to the real estate asset class can be traced back to the early 90s, when Robert Shiller, Karl Case and Allan Weiss authored a paper outlining the benefits of futures and options markets based on indexes representing the value of residential properties in each of the major metropolitan areas of the U.S.
This proposition, cold-shouldered by practitioners for more than a decade, has recently benefited of a splurge in popularity among the financial community largely thanks to the “wild ride” of real estate prices in the last few years, with the median single family home value topping $217,900 in July 2005, according to the National Association of Realtors: an advance of more than 65% over the past 5 years.
This fuelled fears of an upcoming bubble-burst, similar to the one in tech stocks that marked the beginning of the 2000s.
In this context started to take shape the idea of an instrument that would allow to invest in the real estate market and hedge that exposure in a more effective way than buying and selling directly these assets, filling a gap that other securities like REITs (Real estate Investment Trusts) failed to cover in its entirety.
To measure the value of properties the choice has fallen on Case-Shiller Indexes®, named after two of the authors of the 1993 paper, which is published quarterly by Fiserv CSW, Inc.
Widely regarded as the most accurate estimations among the plethora of indexes tracking this sector, these indexes are created using a proprietary model: it starts by collecting data regarding all the previous transactions involving the same home over a period of time, adjusted to eliminate distortions (e.g. non-arm’s length transactions); then the sale pair is aggregated with all the others of the same region to create the index.
CME will list futures and futures options based on the CSI index on ten so-called metropolitan statistical areas, namely Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York commuter area, San Diego, San Francisco and Washington D.C.
Both will be traded exclusively on the Globex®, CME’s electronic platform; futures will be cash settled, expiring in March, June, September and December and they will be value at $250 times the CSI; strike prices for options will be at 5 points above and below market price.
Exchange officials say this market will appeal a diverse crowd of operators: the most likely being home builders aiming at hedging their inventory or, in conjunction with mortgage and insurers brokers, providing some kind of value warranty to buyers fearing a decline in price of their home following their purchase.
Other possible “commercials” interested in this market could be holders of portfolios of mortgages like government-sponsored entities, agencies and other issuers.
The long side of the contract will probably attract all those investors seeking exposure to this asset class, which is largely under-represented in many institutional portfolio due to the low liquidity of the market.
The supporters of this initiative also said that a large-scale success could bring along some of the macro benefits that futures trading has provided to some underlying commodities, reducing the potential impact of a sustained decline in prices and reducing transaction costs thanks to the availability of a whole new array of risk management products for institutions and individual alike.
Though many professionals and academics have expressed favourable opinions about the success of the project, quite a lot of voices raised forecasting this venture won’t go too far.
One objection is that insurers are unlikely to use such speculative vehicles as futures as a way to manage risk and the current level of the real estate market could make these products too expensive to find their way to the public.
Another, more basic, argument is that the underlying indexes, albeit regional, can’t capture fully enough the inherent diversity between the different areas of the very same cities, therefore lacking the quality that would make them sought-after by commercials interested in hedging.
But the main concern that raised skepticism about the whole question and found a way even in the article by Case, Shiller and Weiss has to do with the long streak of failures in previous listings of contracts linked to macroeconomic factors.
Surfing traders’ blogs and forums one find that this news has recalled a lot of veterans in the business the 1991 listing of two real estate contracts on the London Futures and Options Exchange: trading, initiated in May, was suspended in October due to the thin volume and rumors that exchange officials had artificially supported trading volume; another frequently cited episode is the one involving insurance futures and options, that were listed on the Chicago Board of Trade (CBOT) back in 1992; the futures didn’t make it to the end of 1993 and options outlived them for nearly a year before dying out: the culprit? the complete lack of interest by the very same institutions which were supposed to bring that market to life, the same that brought to death the newly-born CPI Index Future on the Coffee, Cocoa and Sugar Exchange in 1989.
The sheer size reached by this asset class, an estimated $18.6 trillion dollars, makes real estate a very desirable arena to play in for the fast-growing derivatives industry especially in times of uncertainty and forecasted bursts: many eyes are pointed to this listing waiting for the response of the Market, which will tell if the project could turn out to be a milestone in the restless evolution of this business or another addition to the long list of failures and false hopes that have characterized its history too.
– AA. VV., Insurance Futures and Options, Papers From The 1994 Insurance Convention, Faculty and Institute of Actuaries, Glasgow, 1994;
– Carpenter, David, New Investment Product Hedges Against Home Price Drops, appeared in Planetrealtor.com, Associated press, Chicago, 2005;
– Case, Karl E., Shiller, Robert J., Weiss, Allan N., Index-Based Futures and Options Markets in Real Estate, Journal of Portfolio Management, 1993 (Winter), 83-92;
– Chicago Mercantile Exchange, Introduction to CME CSI® Housing Futures and Options (brochure), Chicago, 2005;
– Eramo, Robert P., Insurance Catastrophe Futures, Discussion Papers on Alternative Markets/Self Insurance, Casualty Actuarial Society, Arlington, 1996;
– Labuszewski, John W., Introduction to CME CSI® Housing Futures and Options, Chicago Mercantile Exchange, Chicago, 2005;
– Perkins, Broderick, A Future For Housing Futures?, appeared on RealtyTimes.com, Dallas, 2003;
– Shiller, Robert J., “Arithmetic Repeat Sales Price Estimators”, Journal of Housing economics, 1, 1991, 110-126;
By Francesco Galbusera