The Global Home
Robert J. Shiller Commentaries
March 2006
Homes are the most local of investments, rooted to a particular place like a tree, and thus thriving or withering in response to local economic conditions. The whole world flashes by on our television screens, but the market for our homes, which is comprised almost entirely of local amateurs, remains grounded right there in our own backyard.
Soon, however, this could all change. Within a month, the Chicago Mercantile Exchange (CME), in collaboration with my company, MacroMarkets, as well as Fiserv and Standard & Poor’s, will launch futures and options contracts on home prices in ten cities in the United States. The contracts will be settled on theS&P/Case-Shiller Home Price Indices , which developed out of academic work that my colleague Karl Case and I pioneered almost twenty years ago. For many years we have been campaigning for housing futures, but no exchange wanted to use such indices to create a futures market until now.
The futures markets on home prices will allow investors around the world to invest in US homes indirectly, by buying interests in them through these markets. An investor in Paris, Rio de Janeiro, or Tokyo will be able to invest in owner-occupied homes in New York, Los Angeles, and Las Vegas.
A fundamental principle of financial theory – “diversification” or “risk spreading” – implies that interest in the new contracts will be high. People and businesses in New York, for example, are overexposed to their local real estate risks, so they should reduce this risk by selling New York home price futures. People in Tokyo will assume some of this risk by purchasing New York home price futures if the price is right. The New Yorkers still live in their own homes, but now they have spread their investment risk worldwide.
A genuine futures market on single-family homes has not been attempted since 1991 when the London Futures and Options Exchange (now merged into Euronext.liffe) failed in its effort to launch such a market in Britain. That attempt never generated much trading volume. The Exchange threw a party and no one came. British spread-betting markets for home prices, and some retail online markets, have never amounted to much either.
Will it be different this time? To be sure, starting a new market is always an uncertain proposition: people want to go to parties only if a lot of other people are there; if no one is there, no one wants to come. Likewise, in markets without many investors, not enough trades can be executed to generate the returns needed to attract them. As is often true of great parties, it can be a bit of a mystery how substantial new markets get started, but we know that it does happen from time to time.
Initial indications suggest growing interest in futures trading for home prices, particularly as so much talk about the “housing bubble” underscores the importance of diversifying risk. After the CME’s announcement, one of its competitors, the Chicago Board Options Exchange, said that it plans to create futures and options contracts on major US regions, to be based on the median home price published by the National Association of Realtors.
But, aside from strong public interest in investing in housing and in hedging housing risks, another critical issue must be resolved if futures markets are to succeed: prices must be revealed, and investors must understand what these prices mean.
I believe there is a very good chance that many of these futures markets will soon be predicting substantial price declines in some US cities over the next year. They will be in what traders call “backwardation”: the future price in the market today is lower than the price of a home today. Maybe backwardation won’t appear on the first day that housing futures are traded, but there is a good chance it will come within a matter of months.
We may need backwardation in some of these markets if they are to fulfill their function. Everyone knows that there has been a huge real estate boom in many of these cities (and elsewhere in the world) in recent years. International investors are not likely to want to invest in these cities unless expectations of a price decline are built into the futures markets, as people in Tokyo understand from their own bitter experience. But if backwardation is strong enough, even investors who think that the US housing market is headed for a fall will still be able to expect a good return from home price futures, because they are already getting a discounted price in the futures market.
Nevertheless, it will require some adjustment for New Yorkers seeking to hedge their own real estate investments to sell futures contracts that have a built-in price decline. They will have to get used to the idea that the market already expects the decline, and that they can protect themselves only for that margin of possible future price declines that exceed this expectation.
In fact, such adjustments in our thinking will likely occur when we actually see the futures market prices. Until now, the future course of real estate prices has been merely a matter of diverse opinion. When markets create an international consensus on the future price of homes in cities around the world, we will be better able to manage the risks facing these cities, thereby stabilizing their economies – and our own lives.
