Reduce Your Exposure to Falling Home Values

If your looking to buy a home, (or already own a home) but not sure if the market has bottomed out, then you may want to look at selling S&P Case-Shiller Index futures contracts that is equal to the value of your home. Selling these contracts hedges your exposure to a possible devaluation in your home if the housing market collapses (like it has over the past two years) This also enables you to lower your risk of being in a upside down mortgage cause any gain in your investment portfolio is offset by any decline in your home value. I’ll examine how this impacts your investment below.

*A basic understanding of investing in futures and hedging strategy is assumed here*

S&P Case-Shiller Housing Futures are based on the Case-Shiller Home Price Indexes developed by the economists Karl Case and Robert Shiller. These house price indexes are used to show the changes in house prices for single-family homes that have been sold more than once.If you’ve heard in the news that house prices have fallen x% in the last month or year, then it is very likely that they are referencing the data from these indexes.

Example: If home prices fall 50% in the next 3 years, then that means these housing indexes will fall 50% in the next 3 years. It also means you’ve lost 50% of the value of your home. The futures derivatives based on these indexes were designed to protect investors and home builders against the risk of volatile home prices by hedging the value of their property against these housing indexes. One of the less publicized purposes of these products was to protect home owners from losses on their homes.

The Case-Shiller Composite Index (Symbol:CUS) for this last quarter is at 146.00 (data is released with a two-month lag). One CUS futures contract is worth $250 times the value of the index, or $36,500 based on current data. The margin required to trade and carry one contract is $1,314.

Important Information:

Ticker Symbol: CUS

Contract Size: Each contract is valued $250 times the CSI index (if the value of the index for Los Angeles was reported at 267.74, the contract value equates
to $66,936 (= $250 x 267.74))

Trading Hours: Offered exclusively on the CME Globex electronic trading platform Sundays through Thursdays,5:00 p.m. – 2:00 p.m. Central Time (CT) the next day

Benefits of Trading CSI
Futures and Options
• A new means of risk transfer to a broad
range of investors
• Low cost exposure to real estate values
without direct ownership of properties
• Access to a unique asset class
• Opportunity to profit from a movement
in housing prices
• A way to make trading in real estate a
short-term and liquid investment

Contracts
CSI Indices futures and options are
cash settled to a weighted composite index
of U.S. housing prices, as well as to specific
markets in 10 major U.S. cities:
• Boston • Miami
• Chicago • New York
• Denver • San Diego
• Las Vegas • San Francisco
• Los Angeles • Washington, D.C.

How to Invest:

Let’s take the case of a home owner in Los Angeles where prices are in free fall. They bought at $500,000 before the housing boom and their home is now worth the same as what they bought for. They don’t want to risk losing any more equity and want to downsize to another home in about 2 years. This home owner could sell 14 Nov ‘11 CUS futures contracts, currently trading at 146.00 and therefore worth $511,000, which would require at least $18,396 in margin to be placed into a trading account. If house prices fell 20% over the next two years and the index value fell from 146.00 to 117.00, this home owner would have made a profit of $101,500 on his trade and lost $100,000 in home value. Thus leaving the home owner with a net gain of $1,500 in the two year period.

If the home owner sells CUS but the housing market goes up instead, (a losing trade) then any loss incurred from trading can be written off/deducted from taxes and the home owner will still benefit because the value of his house is appreciating.

This home owner was solely concerned with preservation of capital and reducing risk and that goal was accomplished with the above trade(s)

As you can see, this benefits the home owner the most when prices drop the most. In the cases where home prices gain by a substantial amount, they will be required to hold a large amount of money in the account to serve as margin against unrealized losses. But hidden among these simple calculations of profit and loss is the fact that they have been paying down their loan balance for 3 years and will have the same low 5% interest rate on their mortgage. The impact of this is enormous as we’ll show below.

If this home owner bought at $364,000 and the home value dropped by 20%, the home owner can then put all of the profits from the trade into a payment of principal on the mortgage which would bring their outstanding loan balance down to $276,866 in December 2012. This home owner now has $14,344 in home equity due to the huge extra payment. This home owner planned to sell their home in 7 years and will have an outstanding balance of $237,238 at that point. In other words, house prices would have to fall an additional 19% from Nov ‘12 to Nov ‘16 in order for them to have to come out-of-pocket when they sold their home. This home owner could simply elect to open a new futures hedge to protect their equity if house prices were still in sharp decline.

This is not to be considered investment advice. Please consult with a financial adviser to explore all your investment options and the risk involved. Do not attempt to execute this strategy on your own unless you have advanced knowledge and experience in futures trading!