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.

"But the ability to trade has occurred. It's not going to leave. The volatility is too huge."
    As of his data on Sept. 28, the CME product had 1,105 open options, with the bulk-505 open options-hedging on the Los Angeles home price index, he reported. There were 1,441 open futures contracts worth close to $86 million. Miami had the most open futures contracts, 300.
    Siebel agrees with Altfest that the one-year term limit is a major problem with the CME contracts. But he anticipates the Chicago Mercantile Exchange will increase the term to five years, a move that likely would encourage more investors to go long. Chicago Mercantile Exchange spokeswoman Mary Haftenberg said the CME planned to increase the maximum term, but only to two years.
    Before the Chicago Mercantile Exchange product, Siebel says he largely hedged real estate with swaps based on the Office of Federal Housing Enterprise Oversight index. But those were over the counter. The Chicago Mercantile Exchange housing price futures and options, on the other hand, are listed with the Commodity Futures Trading Commission, a factor that gives it more clout with traders.
    The only other program similar to the Chicago Mercantile Exchange program at this writing was believed to be offered by HedgeStreet.com, an electronic marketplace. It also has products listed with the Commodity Futures Trading Commission.
HedgeStreet offers housing "binaries," which work similarly to options. You buy if you think the market is going up, or you sell if you think it's going down. Prices of contracts, which have quarterly terms, are posted in its online order book. If a transaction fails to draw both a buyer and a seller, it doesn't happen.
    Russell Andersson, a HedgeStreet.com founder, says the potential of the real estate derivative market is greater than the real estate market. "Derivative markets tend to be larger than cash markets," he said. "They're a more effective way of transferring risk. They're easier to trade, and transaction fees are lower.
    "We use the National Association of Realtors Index," he said. "They (the Chicago Mercantile Exchange) use the Case-Shiller. The indexes are pretty similar."
    But Case-Shiller, he acknowledges, does a better job.
    HedgeStreet.com's housing binaries are $100 contracts. The Chicago Mercantile Exchange contracts were running $50,000 to $60,000, depending upon the index selected.
    The contracts also are structured differently. They (traders on the CME) buy futures based on a dollar value. Andersson's contracts are bought strictly on the basis of whether they are going up or down.
He also says that you needn't pay a brokerage commission, just a trading fee of $1 per $100 contract.
    Say an index is trading at $30. It means there's a 30% probably of housing values going up. If you're right, you get paid out of the $100 total value of the contract, so you're risking $30 to win $70. If you thought the market was heading down, you'd make the opposite trade, and risk $70 to get $30.
    "Ideally we'd like it to be used for hedging, but before we get there, there needs to be a critical amount of liquidity," Andersson said. "The volumes are relatively small. You're talking in the tens of thousands of contracts traded in any given quarter."
    With heavily margined futures, Andersson notes, you can lose more than you expected. With the HedgeStreet binaries, he says, the worst-case scenario is that you would lose the amount you're risking.
    Siebel admits his commissions are more expensive for trading CME futures and options than for trading stocks. That's because if someone wants to trade, he has to go out and find the other side of the transaction. "It's just not there." However, Chicago Mercantile Exchange spokeswoman Haftenberg notes that commissions are all over the lot. "We're very pleased with the volume," she said, noting that since May 28, it has been trading 45 to 50 contracts daily-some 3,200 as of the end of August.
    In Europe, derivatives on commercial and residential real estate have been trading since at least last year. That market has grown to more than $2 billion, according to Siebel.
    In this country, Siebel anticipates more products to help hedge some of the real estate market's value, including insurance products, exchange-traded funds and other financial investment products. He envisions first-house funds for children. Down the road, he anticipates mortgages that will lower the rate, based on housing prices.