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Time to hedge your home?

In the housing market, the bad news just keeps coming.  And there may be much worse ahead: Futures traders are betting that home prices will fall more than 20% in markets such as San Francisco and Miami over the next year.
/ Source: Business Week

In the housing market, the bad news just keeps coming. This week, the latest release of one leading index which shows that home prices are falling at their steepest rate in 21 years. And there may be much worse ahead: Futures traders are betting that home prices will fall more than 20% in markets such as San Francisco and Miami over the next year.

The latest batch of data was released by Standard & Poor's for its S&P/Case-Shiller home price indexes. The national index of home prices showed a drop of 4.5% from the third quarter of 2006 and the third quarter of this year, and a decline of 1.7% between the second quarter of this year and the third quarter. The 1.7% slide is the largest since the index was first created. "There is no real positive news in today's data," says Robert Shiller, chief economist at MacroMarkets. Shiller developed the index in conjunction with Professor Karl Case and Standard & Poor's (which, like BusinessWeek, is part of The McGraw-Hill Companies).

On Wednesday, the National Association of Realtors reported that sales of existing homes and condominiums for single families dropped 20% in October to 4.97 million units from the same month last year, while the median price of a home sold last month slid 5.1% from a year ago, to $207,800. The price decline was the sharpest year-over-year drop the NAR has ever recorded.

How bad the housing slump will get is certainly open to debate. Lawrence Yun, chief economist at the NAR, says that temporary mortgage problems affected sales volume and prices, but now "mortgage availability has improved as evidenced by much lower mortgage interest rates and a sharp jump in (Federal Housing Authority) endorsements for home purchases."

Still, some investors are betting that things are going to get much worse before they get better. Futures contracts traded on the Chicago Mercantile Exchange show that traders expect double-digit declines in nine out of the 10 biggest housing markets in the U. S. The only exception is Chicago, where prices are still expected to fall by 5.6% over the next year.

Investors' predictions about these real estate markets are certainly not guaranteed to be accurate. But they do provide insights into what people with skin in the game think lies ahead. These types of "predictive markets," have proved surprisingly accurate in forecasting everything from housing movements to the outcome of political elections. They tend to be especially on the mark when the participants have money on the line, as they do in Chicago.

The housing downturn has taken its toll on a wide range of companies. Merrill Lynch and Citigroup have taken multi-billion dollar charges, and their CEOs stepped down under pressure in recent weeks. On Nov. 27, Wells Fargo said it would take a $1.4 billion charge because of losses in its home equity loans. Homebuilders such as Pulte Homes and Lennar have also seen their financials and stock prices suffer.

The options for homeowners in the face of such negative reports are limited. Few people would be willing to sell their homes now to avoid possible declines in the future. But Shiller raised one provocative possibility in a conference call after the latest data were released. He suggested that homeowners may want to consider hedging their homes — looking for ways to protect themselves against declines in their home values. "I believe people should consider hedging their real estate risks," he says.

Betting against your home's value
That is the idea behind the real estate indices that he helped develop. In theory, a homeowner in Boston, Las Vegas, or elsewhere could sell, or short, the futures contract for that city. Then, if the value of that person's home fell, he would reap an offsetting financial gain from the futures contract.

That's the theory. In practice, the housing contracts may not have yet evolved to the point where they would work well for individual investors. The futures contracts for individual cities are thinly traded and on some days, certain contracts don't trade at all. A spokesman for Standard & Poor's says that it's normal for such contracts to start off with low volumes and higher volumes typically come after a catalyst, like the current housing slump.

Shiller thinks such contracts would have quite a bit of value for homeowners as they face an historic downturn in housing. He says the current market is "out of the range of historical data" because the boom was far beyond any previous one for which reliable data exist. In response to one question on the conference call, he said declines of home prices of 50% were certainly feasible. "I'm not going to forecast that, but I think it's a real possibility," he says.