Risk Markets And Politics

Tuesday, May 09, 2006

Ghosts of Futures Past

Mortgage futures have had a rather tortured existence on US exchanges: CBOT GNMA-CDR 1975-87, GNMA-CD 1978-81, GNMA-II 1984, Cash-settled GNMA 1986, MBFs 1989-92; COMEX 1979-8?; ACE/NYFE 1978-81; Hedgestreet 30yr 2004-present. Still others made it to late planning stages but never materialized.

GNMAs, the world's first interest rate futures, enjoyed some initial success but were supplanted by treasury bond futures within a few years. CBOT had hoped that the large underlying market would ensure liquidity, but design issues with the contract undermined its effectiveness in hedging mortgage-specific (prepayment) risk. Several refinements of the contract were tried, but it was too late. Lower basis risk couldn't entice traders away from the already impressive liquidity of the treasury markets.

One hears similar concerns about the upcoming housing futures. That is, if housing prices are largely determined by interest rates, why not hedge in the more established and liquid markets, despite the greater basis risk? Is this just the latest manifestation of the restless mortgage futures spirit? Well, for one thing, the relationship between the Case-Shiller Index and interest rates is unclear. Quarterly returns from December 1995 through 2005 give a correlation of only 35% between the composite CSI and the cash 10-year treasury bond. (Using various lags or mortgage rates didn't seem to improve the significance of this result.) This suggests that the basis risk involved in trying to hedge real estate with fixed income is too large, but note that the CSI only had 3 down quarters in this period, and one might expect the correlation to be more pronounced in a nasty downturn — precisely when the hedge is most valuable.

Second, there is an aspect of the current investment environment that should work in favor of housing futures liquidity. The failed contracts of the '80s and early '90s did not have the advantage of institutional speculation in the form of hedge funds, at least at nothing like the current scale. Recent years have also seen volatilities and credit spreads grind almost relentlessly lower. The global "savings glut" and concomitant yield-seeking seem to have something to do with these trends. There is even anecdotal evidence of funds getting involved in especially unusual investments like baseball teams and film productions. Taken together, these conditions point to an auspicious time to launch new markets — speculators are looking for investment capacity, and this desire will help to mitigate the previously described imbalance.

Some time before the current "prediction market" wave which roughly includes Hedgestreet and INREEX, property futures were given a direct try on the London Futures and Options Exchange. This market, which included a commercial real-estate contract, was open from May to October of 1991. (Robert Shiller recently noted that its launch corresponded with a significant top in real-estate.) The "London Fox" chapter was a bit of a fiasco, as the exchange was found to have created artificial volume via wash trades. The discovery of this mischief hastened the contracts' demise. Perhaps we can write this up to an "execution" failure on the part of the exchange.

In any case, when Shiller, Case & Weiss wrote "Index-Based Futures and Options Markets in Real Estate" in 1992, they seemed more concerned about the failure of the Consumer Price Index futures, which traded on the Coffee, Sugar and Cocoa Exchange from 1985 to 1989. CME and Hedgestreet currently offer CPI contracts, and these also see very light volume. The reasons for the CPI contract's unpopularity are numerous and include the stand-bys of the literature: no cash market, a questionable basis, and similar, more liquid, markets. On the last point, the newer incarnations have to face competition from TIPS spreads, economic derivatives auctions, and even Fed Funds futures. Infrequent updates and manipulation fears were also cited as reasons for lack of trade in the original contracts, and so it would be nice to see greater transparency in the CSI methodology, as was promised. Market imbalance was a problem as well. The government would be the most significant natural seller of inflation, but there is little motivation for such a hedge.

Overall, the housing futures have been in the works for a long time and score reasonably well on the above concerns. We've belabored the market imbalance issue enough for now. Basis risk may be a problem, especially for individuals, but institutional trading and hedgers with large exposure will drive the market. Note how CME is only going to launch with contracts extending one year into the future. Surely, individual homeowner interest would gravitate towards longer maturities. The time doesn't seem ripe for retail hedging just yet. Hopefully, the general public won't catch-on at the worst possible time.

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