Creating markets for risk in residential real estate
Apparently some folks are having problems with comments, and I just noticed that the links to archives don’t work (which is OK, sort of, because you can just scroll down to see old posts).
In an unposted comment on this post, Lucas says:
I liked your idea of the localized MBS tranches but I was
thinking, wouldn’t a futures contract based on something like the
median home price for an area make even more sense? I think real
estate prices tend to get out of whack because of the relative
illiquidity of the market, and the easy access people have to leverage
for the investment. With a futures market, retail investors would be
able to put money into the real estate market without the costs
associated with loans and real estate brokerage. Construction
companies would be able to hedge against risk when building new
subdivisions or other construction projects, and prospective home
buyers would have an investment vehicle that would allow them to
“track” the gains being made in their local housing market and thus
avoid being priced out of the market as they build savings or if they
currently live somewhere else (say while you’re in Philly, you want to
track the Dallas market with money earmarked for a down payment).
I think defining the underlying asset would be the most difficult part, since real estate is very localized (downtown Chicago has a different appreciation curve than the South Side or the Western Suburbs) but contracts for the 20 largest metro areas might have some interest. I t could even be pitched as a substitute for PMI for borrowers with low downpayments (instead of paying PMI have them sell
contracts for their real estate market)……It would probably require too much
investment saavy for a regular consumer but regional banks and
mortgage companies could possibly provide enough liquidity to sustain
a futures market.”
Regarding the futures idea, Robert Shiller has actually talked about getting housing futures going for exactly the reason Lucas suggests. Without having done any reading on how Shiller’s work or their success, I think traditional futures would be very tough to pull off. Futures work best with fungible commodities – goods where a common ‘unit’ can be produced by many suppliers and is acceptable to many consumers. Grain fits this definition, as does natural gas, gold, raw cotton, etc. Another key to futures markets is that since participants are buying and selling a contract on a physical good the futures prices ‘converge’ to the value of the physical asset even though most participants close out their futures position before expiration and delivery occurs. I don’t think Housing futures fit either of these requirements; housing values are highly location-specific, it’s hard to get a ‘fungible’ basket of physical houses that represents the same intrinsic asset from one month to the next (remember the houses in the basket need to actually available for title transfer if the futures contract is taken to delivery). However I think the basic idea (and I suspect this is how Shiller’s plan works) could be tackled by creating an index of housing transactions to support derivatives such as swaps. There is still the issue of relatively low liquidity and how to qualify transactions for the index (4 BR houses 1800-2200 SF? What about quality of schools, age of house, yard size, etc.?). Getting enough transactions into the index to make it statistically usable (hard to manipulate, accurate, etc.) might require making the breadth of geograpy, size, or amenity too wide to be useful. I agree with Lucas that participating in a futures/derivative market is probably too sophisticated for 95% of homeowners and probably not a good idea even if they thought it was. I don’t know who would be long the futures/index either; I can see homebuilders, banks, and short-holding-period homeowners taking the short side but who really wants the long side? Lucas’ thought that future homebuyers would take the longs as they build their savings actually makes a lot of sense, but I can just picture someone screaming to their congressman because they took the long side of this deal while building their savings and then lost all of the savings when the market dipped. If you think the market is going up isn’t it better just to buy a REIT/homebuilder/home/investment property?
Regarding the PMI issue: in my mind (I’m no expert) PMI is protecting lenders from a severe market downturn where people who have very little equity just walk away from their notes as in the mid 1980s oil patch. This risk could be hedged with futures/derivatives as Lucas suggests. However I think that to replace PMI the homeowner would have to basically put the futures into an escrow account – otherwise if they owned the futures outside of their mortgage contract and the housing market tanked they could basically keep the profits from the futures, walk away from their underwater mortgage and double their money. So you’d have to force the homeowner to sign over the profits from the futures (or better, a put option) to collateralize the mortgage. If that’s what you’re doing I think it’s more efficient to just keep the PMI construct – homeowner writes a check for PMI, then the PMI company shorts futures to cover their risk. It’s going to be more efficient and less controversial to have PMI companies doing the hedging instead of the homeowner (and presumably PMI companies would let their end-user rates float based on the premiums they were paying for puts).
Reflecting on what I wrote about real estate in the last post, I still really like the idea of localized MBS tranches; I think it would better let the market charge homebuyers for the local risks in their geography and thus help self regulate bubbles and depressions (the so-called ‘soft landing’ from a market bubble). Tranches could be created for various locations and home types (which already exist, I believe, or at least jumbo/non-jumbo splits). Obviously to keep sufficient liquidity/fungibility in the market some tranches would be very geographically broad (all of Wyoming might be one tranche) but large metro areas should be able to support their own tranche. I don’t think I’m being presumptive when I say there’s a consensus opinion that some urban markets are in a speculative bubble with unprecedented investor leverage and large fractions of transactions being undertaken by speculators/investors rather than resident owners. Say that the San Diego $500,000-$1,500,000 mortgage market is one of these areas and we can break it out into its own MBS tranche. MBS buyers should be cautious of owning these securities (because the high homeowner leverage and speculative market raise default risk); because buyers require a higher than normal yield to hold San Diego MBS, end-user mortgage rates in the area will rise. This will cool down the housing market in the natural cycle of monetary self-regulation. I’m afraid that what’s happening today is that San Diego buyers get a nationally-determined mortgage rate and so do buyers in Wyoming; San Diego homebuyers should be paying more because they’re in a riskier market, but instead everyone gets a blended rate – Wyoming pays too much and San Diego pays too little. In theory tranching gives the market a more efficient self-regulation mechanism than the national-level aggregation we have today; it should keep hot markets from getting too hot and make it easier to buy cheap in cold markets (and get everything back to a healthy lukewarm balance of supply and demand).
Caveat: I don’t know if the MBS market already does this; I know in the early days of the MBS market it was pretty easy to see the individual notes that made up the security; once tranching really took off I think the securities got less transparent since banks had to aggregate so many more mortages into a pool in order to create the 10+ tranches that the market was demanding. This would be easy to check out if I actually had a stake in it or a Bloomberg terminal, which I don’t.
I don’t know if the Feds have laws against charging different mortgage rates in different locations (which basically says everyone has to subsidize the highest risk mortages in the country). I also don’t know how default risk actually trickles down to the MBS cashflows; presumably the vast majority of MBS cashflows are backed by Fannie Mae/Ginnie Mae so I don’t know if a default actually has any effect except altering cashflow timing (or IO/PO splits – I’m not sure if a FHMA-secured default results in a long cashflow stream according to the original contract or a lump sum prepayment of the note). This is a pretty key assumption that I’d need to understand much better before getting too worked up about anything.
Sorry for the length of the post and lack of supporting documentation – I’m stuck on an airplane again with no internet access and nothing better to do.