Tuesday, 10 November 2020

In search of Arrow-Debreu worlds: housing futures

My Newsroom column this week wishes that New Zealand had Case-Shiller markets. 

The relevant bit (Update: now ungated here):

House prices have been ramping up with lower interest rates, perhaps in expectation that the new Government will not enable sufficiently more construction for some time.

If an investor expects house prices to drop, owners of rental properties can reduce their exposure, but otherwise it’s a hard market to short.

Similarly, those wishing to build up enough funds for a house rely on KiwiSaver portfolios that may bear little relationship to the cost of housing.

What’s missing are markets like the US “Case-Shiller” indices. These track house prices across major US metropolitan markets (Canada also has a version). Traders at the Chicago Mercantile Exchange then buy and sell contracts based on the performance of the index.

Saving to buy a house in San Francisco? Buy futures contracts on the index tracking San Francisco house prices. The value of an investment tracks the cost of housing in a desired location. Live in San Francisco and feel dangerously overexposed to an overvalued market? Short the transaction instead.

These kinds of markets let people buy little bits of exposure to the property market in ways a KiwiSaver portfolio generally does not. The value of an investment may fluctuate in dollar terms, but it will move in parallel with the cost of the cute little cottage next to the waterfront.

None of that helps solve New Zealand’s housing shortage – at least not directly.

But it might provide an indirect benefit. It could help in figuring out if policy changes are likely to enable more housing. Suppose the Government tweaks infrastructure financing – or urban planning, or council incentives or new building – and promises more housing within the next few years. If investors found the plan credible, the price of futures contracts on the housing indices would be an early signal.

Letting potential buyers put a toe into the market by buying futures contracts on house prices in a desired area could help them save for that cottage. And it would make their walks through neighbourhoods where house prices outpace some of the best stock-pickers’ portfolios just a bit less vertigo-inducing.

I would love to be able to short housing. 

It isn't so much that I'm expecting a price collapse, but rather that I'm among those who are terrifyingly exposed to housing. Buying a house in Wellington, unless you're on a lot higher income than we are, means a huge portion of your household wealth will be tied up in a house in an earthquake zone. Insurance might fix your house after The Big One, but there's reasonable odds that the city substantially shrinks, and that house prices in the city collapse.

What can you do? You can't insure against that kind of loss. Borrowing against your house to buy other assets doesn't help much because there's no jingle-mail in New Zealand: you can't just hand the bank the keys to a house that's underwater on a mortgage. You still have to pay off the full amount, even if the house is worthless. 

If there were a Wellington Case-Shiller market, you could construct a rolling short. Short the futures market, take the cash now, invest it in other stuff, cover the short later by shorting the next period's market. In effect you'd be able to extract equity from your house without taking on a mortgage, losing the upside of some capital gains, but hedging against falls in the local housing market. If the earthquake hit and collapsed house prices, covering the short would be way cheap. 

There are broader benefits to having signals about market expectations of future relative scarcity. If the government touts some big policy as being The Solution, and futures prices don't move, well, maybe the market's wrong or maybe the policy won't work. 

It could be that NZ just isn't big enough for there to be much liquidity in those markets. Maybe I reason too much from introspection. But if I were currently trying to save for a house, the gulf between house price appreciation and Kiwisaver returns would be driving me nuts. Saving in part by buying the house price index would mean that those savings wouldn't lose value relative to the housing market. 

And from where I am now, I'd like to own less house. Like, if somebody wanted to pay me to buy a third of the upside of any capital gains in my house and taking the same third of any potential capital losses (me paying no rent but them paying no maintenance/rates), giving me a wad of cash that I could invest in things that wouldn't go foom in a Wellington earthquake, well, contracting costs might be a substantial issue but I'd be open to it in principle. Past me would be very keen to pay current me for some exposure to housing, and current me would be happy to sell to past me. Surely there are others out there now who are where I was when we were saving for a house. It feels like the kind of market that should be able to exist, at least if there were enough folks around who think about these things in similar ways. 

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