CBOE Futures Exchange Puts Real Estate on the Radar
By Sarah Rudolph
CBOE Futures Exchange (CFE) launched futures on the Radar Logic 25-Metropolitan Statistical Area (MSA) RPX Composite Index on Feb. 2. We wanted to learn more about the index and the futures contracts, so JLN Options Newsletter editor Sarah Rudolph sat down to talk with John Angelos, director, institutional marketing, credit derivatives, at the Chicago Board Options Exchange.
The credit crisis was disastrous for the market in mortgage-backed securities and spelled the end for over-the-counter mortgage-backed-security (MBS) derivatives that could help hedge those portfolios. Now the CBOE Futures Exchange (CFE) is aiming to give the MBS market a tool to mitigate risk through new real estate futures contracts.
CFE’s entrance into the space is a revival of sorts, using the Radar Logic RPX Composite Index (RPX), which tracks U.S. residential housing values and is one of several Radar Logic 28-Day Real Estate indexes on which CFE is planning to offer futures contracts. CFE’s contracts follow an over-the-counter version of the RPX index that had traded for four years, up until the credit crisis, when the securitization market dried up and OTC trading disappeared, creating a void. But mortgage-backed-security portfolios haven’t disappeared; they still exist all over the U.S., and MBS portfolio managers need a new way to hedge their exposure, according to John Angelos of the CBOE.
The idea evolved from portfolio managers who came to Michael Feder, the owner of Radar Logic, to help them find a way to fill that void by creating a tool to mitigate their risk. They introduced Feder to the CFE, which came up with a futures contract based on the Radar Logic cash Index.
Radar Logic calculates residential property indexes on the U.S. housing market as a whole, as well as indexes on four U.S. geographical regions, and on 25 individual U.S. metropolitan areas, using price per square foot, a commercial metric applied to the residential real easte space. The initial RPX futures contract, based on Radar Logic’s National Composite Index (NCI), began trading on CFE on February 2. The index is composed of 25 metropolitan statistical areas, which feed into the National Composite Index. It is calculated using new and existing home values on single and multi-family homes (meaning condominiums).
To anyone familiar with the residential real estate market, there is already a well-known index used to measure home values – the S&P/Case-Shiller Home Price Index. The Case-Shiller indices track changes in the value of residential real estate both nationally as well as in 20 metropolitan regions. Options and futures based on the index are traded at CME Group.
Angelos acknowledged that Case-Shiller is a comparable product, but argues that it was created to be an econometric tool, a gauge of activity in the real estate space, rather than as a tradable instrument.
“Case-Shiller only looks at existing homes,” he said. “They don’t look at new sales. They compare a resale of a home and then look at the increase in value from that home. Also, they only look at single-family homes. As a result, they need to gather a lot of data points to be credible.
In addition, he said, it takes Case-Shiller 90 days to gather enough data points to calculate their index, whereas the RPX Composite index is calculated in only 28 days.
“The problem with this space is that you’re already looking in the rear view mirror by 60 days. You have your point of sale on day one, and your closing 60 days later. So you don’t even get access to that number for 60 days. Consequently, you want to shorten up that data collection period as much as possible without adversely affecting the integrity of the data to get as close to real-time information as possible,” Angelos said.
Radar Logic calculates and publishes that number every day, rather than once a month as with Case-Shiller.
“I think we are targeting two different types of end users, with two different purposes,” said Angelos.
The natural participants are MBS traders with a portfolio of residential mortgages, he said. However, because so many people have exposure to the residential real estate market, there are many uses for the contracts, he added. Real estate developers, for example, have beta risk in the market between the time they build new homes and when they can sell them. In the interim, they can hedge their downside exposure with RPX futures.
Real estate agents who want to sell houses are in a bind in the current deflationary environment, where a typical home buyer might hesitate to buy a house today when the likelihood is it will be cheaper tomorrow. According to Angelos, a seller can use the RPX futures to give the buyer downside protection between now and up to five years. Theoretically, the buyer won’t lose money between now and maturity, and the home seller can then use the futures market to lay off that risk.
Or say you live in Chicago and plan to retire in 10 years to Florida. Once the individual 25 Metropolitan Statistical Areas are launched, you can use the RPX futures to lock in Florida real estate prices in today’s dollars, thereby hedging against inflation. Meanwhile, a speculator who believes the residential market will go higher can synthetically create a portfolio of homes using the RPX futures, a cost effective way to gain exposure without the need for a home mortgage.
At the outset, Angelos said, those most likely to take the opposite side of the hedgers will be speculators taking the long side of a trade. Hedgers will likely take the short side.
The exchange plans to roll out contracts on the four U.S. regions (Northeast, South, Midwest and West) as well, and then on 25 metropolitan statistical areas (MSAs). The SEC has approved the listing of all of those contracts, but CFE’s strategy is to begin with the National Composite Index and let that build liquidity before they release further, more granular, products. The exchange also wants to let the Barclays market makers, who have been trading the OTC version of the contract for years, get accustomed to trading an exchange-listed product.
The futures have an expiration in March and in September in 2012, 2013, 2014, 2015 and 2016. When you line up those data points, Angelos said, “It’s a term structure of future expectations of home prices. There is a seasonality to the data, and it’s currently upward sloping. The first trade we had was a curve trade – a trader did a spread trade based on the curve of future home values. One of the legs was a seller, the other leg was a buyer.”
Angelos says the exchange has had calls from Fannie Mae and from potential buyers of Fannie Mae’s assets.
“Fannie Mae is eventually going to have to unwind their portf
olio, get rid of their assets, and someone is going to have to buy them,” Angelos said. “Am I more willing to buy it if I have to take on 100 percent risk, or am I more willing if I can hedge some of that risk?”
The CFE believes that if the listed contract drums up some momentum, the OTC space could come back to life. In the prior OTC market, about $4 billion in notional value was created through structured products and used as a hedging mechanism. The new futures contract could enable someone with a concentration in one particular residential area to take a futures position in the National Index and parcel part of it out in the OTC space. Ultimately, Angelos said, there is potential for a symbiotic relationship between the futures and the OTC market.
Fannie Mae and Freddie Mac have been approached by people who were interested in using the RPX futures contracts and wrapping them around structured products, Angelos said. They could potentially create interest among investors for those products, while still creating upside incentives for homeowners to stay in their homes.
“There are a lot of creative minds out there figuring out how to use our contract. A lot of interesting things can be done with this,” Angelos said.