Looking at the housing market as a futures market

The overheated housing market has taken many by surprise and turned many away, but while markets ebb and flow there is a strong argument for a more sophisticated futures market in house prices in the UK and elsewhere.

Toby Melville/Reuters/File
Residential housing sale and letting signs are seen in Hastings in southern England, January 3, 2008. Banks expect to cut back further on lending as a result of the credit crisis, the Bank of England said on Thursday, while Federal Reserve policymakers thought big interest rate cuts may be needed to buoy the U.S. economy. Corporate credit availability was also reduced sharply and conditions look set to tighten further in the next three months while mortgage defaults were likely to rise, the survey showed.

Property is, for the majority of citizens, the single biggest investment made in a lifetime. Most people’s portfolios are far less diversified when you factor in the fraction that is dominated by house price movements. Indeed, many who would consider their wealth relatively ‘safe’ from fluctuations in market prices by keeping the majority in cash are far more dependent on economic circumstance than they realize, owing to the large investment they have made in bricks and mortar.

‘Sophisticated’ investors can hedge most investments through futures markets in the particular investment, but housing is unique in having a futures market that is ‘index-based’, i.e. you can hedge risk for the market movements as a whole, but not for your particular area or property. Property is inherently heterogeneous, and just as derivatives instruments have blossomed and specialized in other areas over the last decade, housing derivatives should do the same. Everyone has to buy a house, so why not allow people to hedge against the particular risk they are taking in doing so.

Credit goes to Robert Shiller for the popularization of this idea, and interesting research (drawing from techniques of the biomedical sciences of all things) has been done into the nature of heterogeneous derivative instruments. I think that the broad argument for widespread involvement in such markets is worth restating though.

I would argue that recent events highlight the need for such a facility in the housing market. When house prices plunged in 2008, UK citizens where clearly horrified at the amount of their net worth that was evaporating after years rising in an overheated housing market. As a result, consumer spending dropped and recession deepened.

This wasn’t the first overheated housing market, and it surely won’t be the last; loose monetary policy seems to be a specialty of this generation of central bankers. I think this only strengthens the case for a hedging facility in housing. If people had less to lose from a drop in house prices, the economy would be more robust and efficient as a whole.

The argument for a more sophisticated futures market in house prices is even more convincing in the UK, where the proportion of buyers to renters is much higher and house prices in general are higher.

There is a need for this market, and clear profit opportunity for firms involved. I’ll keep harping on until more notice is taken.

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