Why CME housing futures prices are useless

Justin Lahart has a look at how the nascent market in housing futures is getting on in Chicago, and finds some eyebrow-raising figures:

The contracts suggest price drops by next summer for average single-family homes will range from 5.9% in the Chicago area to 8.5% in San Diego and Miami areas. A contract based on 10 regions suggests a 7.2% decline.

Lahart points out that there might be too many sellers: too much demand for hedge, without much in the way of buyers. He also notes that the market is pretty illiquid, which is a masterpiece of understatement.

There are 11 different futures contracts, and each one comes in four different flavors: February, May, August, and November. There is a total of 1,500 contracts outstanding, which means that any given futures contract has an average of just 34 contracts outstanding.

Let’s say I’m financing a new condo development in Tribeca, with say 50 units at an average of $2 million each, and that since it won’t go on sale until late next year I want to hedge the downside on $100 million of New York property. In other words, if the market goes down by 10%, I want my futures contract to pay out $10 million.

The Shiller-Case index for New York currently stands at 214. Each contract pays out $250 for every point that the index drops, and I want $10 million if the index drops 21 points. So I need contracts worth about $476,000 per point, or 1,900 contracts in all – more than the total amount of contracts which have been sold so far across 44 different futures contracts.

If I owned the entire average amount outstanding in the New York August contract, I would be hedged by $8,522 per one-point drop in the New York market, or $18,238 per percentage point. Which would be a perfect hedge if the value of my New York property was $1.8 million – roughly the price of an average Tribeca 2-bedroom condo.

Obviously, there isn’t remotely enough liquidity in this market for Latham’s “Florida home builder with a big development in the works,” let alone for hedge funds or any other institutional investor to make non-negligible amounts of money by taking the long side of the trade and betting that prices rise. In fact, there’s really no one who’s a natural buyer of a dozen or so futures contracts, which means that the chances of a liquid market ever getting off the ground seem slim.

It was a good idea, but so far it clearly hasn’t worked. Latham says of the contracts that “if they catch on, they could become more important to watch than the reams of housing data that economists spew out each month.” And if pigs learn to fly, then housing prices could fall by 76% in one year.

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