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Basics -Convergence

With the expiration of the August contracts approaching, I thought that it might be useful to illustrate how convergence in the CME Home Price futures contracts as taken place in the past.

The graphs are of 1) the Nov 2007 CUS contract, 2) the Nov 2008 contract, and 3) the Case-Shiller CUS index over time.   Closing prices on the CME contracts are noted by the lighter shaded lines.  Actual trades are noted with darker squares.

A few observations:

1) (A simple one) The CME contracts trade daily, while the Case-Shiller index is only released monthly -hence, the infrequent, step-function in Case-Shiller numbers.

2) Note that trades tend to result in changes to prior closes.  (See Basics blog on Closing for more details.)  Note how in the Nov 2008 series that the closing price was unchanged at 183.8 from Feb 3-26 until a trade took place at 176, which then resulted in the subsequent lower close.  (Again, getting back to the point that I’ve harped on that “Closes” may not necessarily represent current sentiment.)

3) Note how prices on both series converged toward the CS index that was released in the month the contract expired.    As prices for the contract must be the same as the index at expiration any large variance from the expected CS index can be arbitraged.  As the CS index is a lagging, moving-average index, it is extremely unlikely that the CS index will dramatically jump in any month.  This means that longs and/or shorts have an ever clearer picture of the eventual value of their outstanding positions.

4) As such, an option for longs/ shorts is to hold positions to expiration.  While this may dampen trading (bad for me as a market maker) it gives increased confidence to those thinking about entering new positions that they won’t be subject to wide bid-asked spreads if they hold the position to maturity.  This increased confidence should give more people comfort that they can use these contracts as longer-term hedges (or insurance) against long/underweight positions (good for me as a market maker.)

5) Finally, note that early in 2008 the Nov 2008 contracts traded to pronounced discounts to the then spot Case-Shiller index.  Did the contracts incorporate a consensus view that home prices had further to fall?  Were sellers so desparate to find a hedge to other real-estate related exposurses that they oversold the contracts?  Were the longs just being adequately compensated for providing a service (protection against a melt-down in home prices) that required a sufficient rate of return?  All of these questions are the themes of academic studies that should be reviewed.

Book Review – The Housing Boom and Bust (Thomas Sowell)

One of my roles away from here is that of  moderator for a book club at my local library.  (Non-fiction, primarily foreign affairs and current events)  That role has reintroduced me to a love of reading that proved elusive with a life (in the early 2000’s) of early business meetings, client presentations, and getting the kids off to bed.  As it takes reading three books to find the one I can recommend to the group, and since “the crises” has been so much on every one’s radar, I’ve had the chance to read them all.  (Collapse of Lehman, Collapse of Bear,  Collapse of AIG, Collapse of …..).

The book that stands out from that crowd, that I would like to tout here, both for being well-written and due to its relevance to this site’s themes is  –The Housing Boom and Bust(revised edition) by Thomas Sowell.

Mr. Sowell’s approach is to explain (in the newly updated, slim paperback version)  how forces (incentives, mostly) built up over a period of years, were the reasons behind the inevitable real-estate crash.  He tars politicians (both local and national, Democratic and Republican) with their use of policies that were designed to appease either in the short-run, or to limited constituencies.

A conservative by nature, he suggests that “Affordable Housing” programs represent an intrusion by the government into market practices.  He argues that many of the affordability products that were created during the boom years, that were designed to increase home ownership, by having banks lend (and then securitize) to those borrowers, were only made to appease mis-guided government policies.

While the common wisdom is that we all learn from our mistakes, he offers a dire, but critical forecast that  “…those who say that politicians never seem to learn overlook the fact that there is no reason for them to learn, when they pay no price for being wrong when they can simply blame others and continue on with policies that have been politically beneficial to themselves, however detrimental those policies may be for the country.”  (No surprise to WSJ readers, Mr. Sowell cites Congressman Frank and Senator Dodd several times as their roles and views on housing policies have “evolved”). 

This is the best book that I’ve read on the roots of the real-estate financial crises (although there are some other great ones on how money was made or lost).   They say  ” If you want to know where you are, figure out how you got here”.  This book does a great job showing how small, well-meaning actions, took us down the path to where we are today.

Similarly, if you want to figure out the political angles on key issues related to home prices down the road (e.g. fiancial regulation, the role of the GSEs), and to home price futures contracts, then I strongly encourage you to read this book.

Basics – CUS Calculation

It might be useful to walk through the calculation of the CUS (The 10-city Nationwide) index once, as the index presents an opportunity for possible trading strategies.  To start, the table (below) lists the weights of the index and shows the weighted average price of the 10-cities for the May CS release.  (Weights are from S&P report on Case-Shiller index archived here under reports tab.)  Thankfully, the weighted average for this exercise equals the published index result.

 With these weights in mind, one can attempt to trade forward values of the index or the key underlying cities in an attempt to take advantage of discrepancies, trends or relative liquidity.  For example note that two cities (NY and LAX) make up more than 50% of the index (weighted by price index).  Changes in those two cities alone may dominate the value of the CUS -particularly if others (say Denver) remain relatively quiet. 

Recently NY and LA have been moving in opposite directions (NY one of two cities that fell in value last month) while LA, and the West Coast cities of SF and SD that in total make up 40% of the index by weighted average, have been the stars.   Those offsetting effects have somewhat dampened price moves in the CUS.  As such there may be trading opportunities if the bullishness of certain markets spills 1:1 into the CUS index while NY lags.  However should California and NY ever begin to move strongly together (up or down) look for the CUS to become more volatile.

Basics – Home Price Indices

There have been some questions about  – “Why use the Case Shiller index”, and “How does it differ from other indices”.  Deutche Bank summarized the differences between the Case Shiller (CS), National Association of Realtors (NAR), and OFEHO indices in the attached writeup from March 2009.   Please contact your DB coverage for copies of the full report.

Definitions of three widely used home price indices

The S&P/Case-Shiller Home Price Index (HPI) measures the prices of repeated paired sales of single-family homes in the U.S., excluding refinancings, home improvement and investment purchases.  The data underlying the index is retrieved from house deeds recorded at county courts.  The S&P/Case-Shiller national HPI is reported quarterly, with a tw0-month lag.  At the MSA level, S&P Case-Shiller provides data for 20 MSAs, which is available monthlywith a two-month lag.  (This nationwide data is available for free for both national and MSA data series at http://www2.standardandpoors.com).  For expanded MSA coverage, additional data can also be purchased from Economy.com (http://www.economy.com/home/products/housepriceforecasts.asp)

The OFHEO House Price Index (HPI) measures paired repeated “sale prices” of single-family homes in the U.S., but also includes refinancings. For a refinancing, the value of the home is based on an appraised value, not an actual buy-sell transaction. Because appraisals can lag the actual market, including appraised values in a home price index along with actual selling prices may create an upward bias when prices are falling. The data underlying the index also covers only conventional conforming mortgages provided by Fannie Mae and Freddie Mac.  By excluding jumbo mortgages, the index may also understate deterioration, as (traditionally) higher-priced homes are more volatile. The OFHEO HPI is reported quarterly, with a two-month lag. (Data is available for free at http://www.ofheo.gov/HPI.asp.)

The National Association of Realtors (NAR) House Price Index (HPI) measures the median sale prices for existing single-family homes sold in the U.S. The data underlying the index is retrieved from local associations/boards and multiple listing services nationwide. The NAR HPI is reported quarterly at the MSA level, with a two and a half month lag. The data is alsoavailable monthly at the national and regional level (i.e. Northeast, Midwest, South and West), with a one-month lag. (Data is available for free at http://www.realtor.org/research.nsf/pages/ehspage.) While median data has its limitations, this source is also the most timely.

 

Basics -Front Contract Expiration

A good way to learn how CME Home Price futures contracts work is to watch as the front contracts reach expiration.  Recall that the contracts have settlements in the current year at 3-month intervals (Feb,  May, Aug, Nov) and that the contracts “Cash-Settle” – that is the value used to settle an open position is the index number published on the last Tuesday of that month.

The May 2010 contract is approaching expiration as the S&P Case-Shiller index results for March 2010 will be released on May 25th.  Since any open interest will be cash settled (absent a closing trade) on the numbers released on May 25th, bids and offers tend to converge toward the expected index numbers.  That tendancy has the effect of narrowing the bid/ask spread.  As of today, May 13th, the bid/asked spreads in the May ’10 contracts range from 1.20 to 4.60 points (or 120 to 460 as quoted by the CME).    Recall that the CME contracts trade in 20 cent intervals and that 100 points (or 1.00 on the CS index) is worth $250.

The New York contract has the distinction of being the only contract where the current offer is lower than the prior month’s index.  (There are no higer bids than last month’s CS index). 

 

 

 

 

 

 

 

 

 

Any long/short position that needs to be rolled forward could do so either by legging the two sides of a trade (e.g. buy/lift/cover May ’10 short while trying to set a new short position in a more distant contract).  Given the illiquidity, a better approach (if one has to roll) is to enter orders in the calendar spread markets.  That is, one could place an order to execute a Buy May ’10/ Sell Aug ’10 at a certain price spread, but only if both orders were executed at the same time.  Again, while the calendar spread execution is better than legging each side of the trade, the bid/asked spreads have tended to be wide.  (I’m working on that next and will respond to inquiries.)

Finally, while contract expiration may be interesting, and there may be opportunities for trading (and thereby providing liquidity) at the end of the day most core real estate investors and hedgers are looking much into more distant contracts 18-36 months out to express their views. 

 

 

Basics -Geographic exposure

The question has frequently been asked – what specific geographic exposure am I getting when I buy the New York,  Miami,  San Fran, or any other contracts. 

Page 8 of the S&P/Case-Shiller Home Price Indices Methodology report (found in the Reports section here) lists the areas covered, by county, for each regional index.   In reviewing the lists, one can see that these are not strictly “City” indices in that home prices some distance from each city’s downtwon area are included.   (Anyone intending to trade any product referencing the S&P Case-Shiller index shoud read the complete report to understand not only the reference geographic areas, but all other aspects of the index calculations.)

In addition I’ve attached here a map from MacroMarkets (Robert Shiller’s firm) that highlights the span of the New York index, as an example.  A New Yorker may appreciate that home prices in an  area that stetches from New Haven, Ct. to Duchess County, north of NYC,  down to Ocean County in NJ on the shore, may not all move in unison with the rest of the regional index area.  There’s a tradeoff  in that the larger the reference area, the greater the number of possible repeat-sales, and the more current, robust and accurate the index.  The advantage of fewer, larger regions, is that you not only elimate nuances of a particular town, but you avoid fracturing trading into an excessive number of regional contracts, each of which would have much less liquidity. 

While somewhat dispersed, the NYM index performance has been genearlly reflective of broad changes in local real estate repeat sales, for many areas, as much of the area’s home price movements may be tied to the fortunes of the New York City economy.  (As an exercise map what you think your own home has been worth at various point in time over the last 10 years and see if it’s tracked the index.)

Does a large regional index introduce some basis risk between a house in one town versus the larger region?  Of course, but many indices and commodity contracts (such as the CME Home Price futures contracts) have that basis risk in either how reference obligations are defined, or in the seller’s ability to deliver different assets.  It’s just the trade-off that’s made to create an index (or a contract) that can be viable for hedging regional systemic risk.

The same could be argued for each of the other 9 regional indices.  Please refer to the MacroMarket website http://www.macromarkets.com/real-estate/ for maps of the those regions.

 

 

 

 

Basics -Calendar Spreads

If you look at the CME Website for prices (see link) you’ll see a pulldown menu for quotes for either calendar spreads or inter-city spreads across all 11 indices.

 http://datasuite.cmegroup.com/dataSuite.htmltemplate=hsng&leadMonth=NYMK0&strategyType=SP&category=Housing&exchange=XCME&selectedProduct=NYM&selected_tab=real_estate_tab 

The calendar spreads are useful for expressing views about the timing and magnitude of price changes. For example, if one thinks that prices will be higher in Nov. 2013 than Nov. 2011, one could sell the spread (sell the front contract and buy the back contract) at “flat” (the contracts at the same price) or for some positive spread (spreads are always quoted in terms of the front contract relative to the back contract so a positive spread implies that the front contract is trading at a higher price). If between now and then the market starts to price in a rise in the index between Nov. ‘11 and Nov ‘13 the spread could go negative -resulting in a profit.   

                          
One caution on calendar spreads – at expiration the front contract will cash settle leaving you holding just the forward postion.          

                                          
Another note, some calendar quotes are just computer generated combinations of a correseponding bid and offer. For example if Aug ‘10 is bid 17000 and Nov ‘10 is offered at 17240, a spread offer in Aug – Nov. ‘10 of -240 will likely be showing. If executed, a computer program will “lift” the offer at 17240 and “hit” the bid at 17000, backing into the -240 spread.          

                                                                                                                                    
Finally, calendar spreads can be entered as GTC while inter-city spreads must be entered (and renewed, if desired) as day orders.

Basics – Closing prices

How does the CME post closing prices on 11 home price contracts (the 10-city index and the 10 individual regional prices) over 10-11 expirations so quickly after the close?  They have a rules-based methodology that they follow, that sometimes generates some odd-looking results.

One of the challenges of a thinly traded futures contract is that closing prices, particularly on the more distant contracts,  may appear “out of whack”.  For example, the 25-point  higher closing price (relative to other expirations) for the San Diego Nov. 2012 contract (as of 4/30/2010) may not be due to any fundamental reason.  The CME is just following their methodology of calculating the “closing price” based on either the: 1) last trade, or 2) a subsequent higher bid, or lower offer.   Higher bids in the May 2012 contract or the Nov. 2013 contract, or lower offers on the Nov. 2012 contract would “smooth out” this closing curve, but as there is no open interest in those expirations, quite a bit of time may have elapsed since the closing price changed.

(Qualifier: I’m not saying that May 2012 is “too low” or Nov. 2012 is “too high”.  I’m just highlighting the differences between the two to explain the CME methodology to posting closing prices.)

The kinks in closing prices (such as those in the displayed San Diego contract) become more pronounced when the market has trended in one direction, but where trading (or quoting) has not kept pace with market moves.  More frequent trading and/or higher bids/lower offers will more likely keep closing prices closer to “reality” and eliminate the kink we see in this graph.