The derivatives are here; are they the answer?

    Ways to hedge a client's real estate are coming out of the woodwork. After all, the real estate market is a $21.6 trillion market-more than the $15 trillion stock market.
    But are the newest real estate derivative products worth using for clients?

It seems like a utopian solution. Your client is worried the price of his or her home will drop in the next few months. So why not hedge the loss?

Options and futures index contracts on the Chicago Mercantile Exchange (CME), which have been trading since May, are designed to make this easier.

With them, your client can buy or sell contracts that agree today on a price, based on home price values tracked by a series of 11 housing indexes. These include a composite index and indexes on ten major cities.

Expect housing prices to tank? Your client can sell short a futures contract based on the S&P/Case-Shiller Home Price index in his or her market. The contracts mature up to one year into the future. If the index price drops below your originally agreed-upon price, your client profits on the difference between the two prices. The cost per contract is $250 times the selected index. As of July data released in September 2006, that ranged from 140.25 in Denver to 278.33 in Miami. One to 5,000 contracts are permitted.
    Futures contract prices change constantly. Each fluctuation of one "tick," or .20 of an index point, from your client's original agreed-upon index value results in a corresponding account credit or debit of $50 per contract. Your client needn't invest the full amount of the contract, but each account must maintain a specific initial minimum, running from $1,300 to $2,000, to continue trading.
    Prefer an option? Say, you buy a put option on a future based on the specific market index. This buys the right, but not the obligation, to sell a futures contract within a stated period at a predetermined price. If, upon the option's expiration, the market is below the strike price, your client gets the difference. If it's higher, he or she loses only the price paid for the option.
    The Chicago Mercantile Exchange plans in 2007 to add another derivative product linked to a series of GRA Commercial Real Estate Indexes developed by Global Real Analytics LLC in San Francisco. Plus, Goldman Sachs has signed a licensing agreement for the development of financial products based upon S&P/Case-Shiller Home Price Indices.
    So far, however, not many are jumping on the new derivatives bandwagon. "It's been very unsuccessful," declared Scott Simon, managing director for mortgage backed securities for PIMCO, Newport Beach, Calif. "There have been weeks when the entire trading volume, a guy couldn't have hedged his garage!

"They'd be interesting if you had people who really wanted to speculate on the long side."
Simon, who believes you're better off selling your home and taking a loss if you think home prices will drop, also warns that the Case-Shiller indexes are regional. They may have nothing to do with your client or the home that's being hedged.

Fee-only advisor Lewis Altfest, president of L.J. Altfest & Co. Inc. of New York, agrees.
    Housing prices, he notes, are very different in Manhattan from, say, certain sections of Brooklyn. Also, he reports, he was able to pick up a Park Avenue, Manhattan, location for his office at a low point in the commercial real estate market last year, just as the residential real estate market in most other areas peaked. Yet, despite the disparate markets, the only index the Chicago Mercantile Exchange offers for "New York" is based on the residential market.

Altfest says he has been looking at the CME products seriously for clients who are in a position to buy a very expensive home and want to do it now. "They are very nervous about getting hit."
    Problem: "You're not going to be able to buy a long-term hedge right now," Altfest says. "The markets are not there yet."

As a result, you have to keep rolling over the hedge, perhaps picking up added costs and commissions. "You may be paying a greater spread than you need to."
    Another critical issue to consider: If you're hedging a home, you have a cash transaction on one side. "The other side of the transaction, the house, is illiquid. So you had better take that into account."
    Fritz Siebel, director of property derivatives for Tradition Financial Services Inc. in New York, an institutional brokerage, admits that he trades just 200 to 250 of the CME contracts weekly. Most of those using the products are professional investors and some smaller developers, he says.
    But he disagrees that selling a property and taking a loss might be a better option than hedging with the new CME products. In August 2006, the CME contracts indicated that housing values will be dropping 6% to 8% into 2007, he said. "Who's to say this is done?"

He admits that some heavily margined futures sellers could lose their shirts if no buyers materialize. Or, some could be forced to sell at prices that don't make sense. "When you trade futures you are taking on risk, no question about it. You should see the disclosure forms! But I know some people who are doing really nicely. They're picking their moments. When the Fed did not raise rates there was some buying that came in. Now the data are looking pretty poor again."
    Siebel is not deterred. "Derivatives are a $20 trillion market. The idea that we can trade housing prices the way we trade stocks and bonds-basically, it's been born. It's in the neonatal unit now. It started before Memorial Day weekend. It might be a child for a while or it might immediately start crawling or walking.