Thanks to rising prices, homeowners increasingly view their houses as investments. At the end of 2004, U.S. residential real estate was worth $18.6 trillion—more than the entire stock market. The National Association of Realtors reported that 23 percent of homes bought in 2004 were investment properties. It's no surprise that there's now a company, Condoflip.com, which aims to let people trade homes the way they trade stocks.
More people have more riding on their homes—and second homes—as investments than ever before. And yet there's no good way to insure those investments. Homeowners policies only cover the infrastructure from physical damage. But if your home falls in value from $1 million to $750,000 thanks to market dynamics, you can't call Allstate. So far, the only methods of hedging against the value of your home are crude and inefficient. You can short the stocks of publicly held home-building companies, like Toll Brothers or Pulte, or buy and sell options on them. But when you do so, you're betting on management and all sorts of other factors. There's no guarantee Toll will fall when the value of your house drops.
Next spring, however, investors might finally have a better hedging product. Just in time for the apparent top of the housing market, the Chicago Mercantile Exchange is introducing futures and options on housing prices in 10 cities for the second quarter of 2006. (Here's an overview of the products, and CME's White Paper on the topic.)
These derivatives are largely the brainchild of one of the leading apostles of investing caution: Robert Shiller. Author of the prescient best seller Irrational Exuberance, the Yale economist has a fecund academic and entrepreneurial mind. Along with economist Karl Case, Shiller in the early 1990s developed a method of tracking home prices and devised indexes to chart the rise or fall in home values. The company he helped form in 1991, Case Shiller Weiss, was acquired by Fiserv in 2002 and compiles Case-Shiller Indexes for 10 markets, including Boston, Chicago, Los Angeles, Las Vegas, Miami, New York, and San Francisco. In 2004, Shiller and CME announced they would work together to create options based on the indexes.
When they debut next spring, the options will be pitched to big-time real estate owners, builders, mortgage lenders, and hedge funds. A builder putting up a $100 million subdivision outside Chicago ready for sale in 2008 could buy puts on the Chicago housing index that expire in the summer of 2008. If the housing market plummeted and the company took a bath on the McMansions, it would recoup a chunk of the losses on the rising value of the puts. But it's unlikely that the people who could most benefit from hedging—individuals—will be big users. Why? These options will cover large markets—it will be tough to hedge the value of your own house, which depends so much on your particular neighborhood. The Case-Shiller New York Commuter Index covers single-family residential homes from the Jersey Shore to New Haven, Conn., a remarkably heterodox stretch that contains markets and submarkets and sub-submarkets.
There's also a psychological barrier. Individuals have shown a great propensity not to buy insurance on financial assets, even when such insurance is readily available. Most individual investors don't hedge their large stock holdings: Did you buy puts on the Nasdaq-100 Trust to guard against the drop in your tech stock portfolio? What's more, recent history shows that investors tend to assume that unsustainable gains will continue, investing more money into overheated sectors rather than hedging them. Before the market crash in 2000, investors weren't grasping for advance copies of Shiller's Irrational Exuberance;they were gobbling up Dow 36,000,an uncautionary book written by different shillers.
In his most recent book, The New Financial Order,Shiller proposes another way homeowners might be able to hedge against the value of their home—a way that wouldn't require options. What if you could take out insurance policies on your home equity? You would buy insurance guaranteeing that if you sold your house, you would get at least the, say, $200,000 in equity you have today. Financial services companies would do the complicated risk analysis to figure out what that should cost, given the direction of the housing market, etc. "With the vast electronic data sets of home prices now available, it is possible to devise indices for many small geographic areas, even for individual neighborhoods within a city," Shiller writes. This isn't idle academic speculation. Shiller and several Yale colleagues have started the Home Equity Protection Project, which has been offering residents of Syracuse a way to hedge their home investments since 2002.
The CME's housing options exemplify 21st-century financial innovation. But the overwhelming majority of home investors will likely find the options too scary and complicated. So, it may be that those seeking to protect their housing equity may resort instead to a 19th-century financial innovation: home insurance.