Saturday, October 30, 2010

Matt Yglesias wonders if people have to speculate in housing. What if someone wants to buy a house but doesn't want to gamble that house prices will increase ? Is there anything to be done ?

In theory, this problem has been solved. It is now possible for home buyers to hedge. It is also possible for professional investors to speculate in housing. I'm not sure they would do better than the amateurs, look how well the RMBS and stock markets function.

The solution, in theory, is the Case-Shiller house price index. You can roughly hedge the price of a house you own using the index. The problem is that the risk you want to hedge is that you want to sell the house and it is cheap. So long as you own the same house, the price only matters for property tax assessments.

Shiller really really honestly believed that he had made the world a much better place when he confinced the Chicago Commodities board to introduce trading in the index. But then almost no one traded it (what if you held an index and nobody came ?).

I think that the correct innovation which will really fix things is one in which the balance of a mortgage is indexed to the Case_Shiller index. If the index were perfectly matched to your home, your equity in the house would just grow with repayments minus interest. Oh the interest to be paid would be constant (OK indexed to wages or the CPI to be perfect), not a constant times the balance owed. So, to the extent that the index worked, interest and principle payments and equity in the house wouldn't depend on housing price fluctuations.

This makes mortgage initiators waay long the local Case-Shiller house price index, but they can hedge that risk by shorting it.

Problem solved except for people who own their houses outright and, hey they can bear a bit of risk.

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