Property price derivatives price in 19.5% LA house price drop next year

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earthbm_IHB

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Brilliant resource, so I thought I'd give something back, being in the investment industry. There is a market for Total Return Swaps (TRS) where you pay (or receive) a fixed interest rate vs receiving (respectively paying) one of the recently constructed home price indices (these tend to track same property sales). There is no O.C. index that is liquid enough to have its own trading but LA is close enough. Now even LA is not liquid enough to have 3yr contracts trading, but even over 1yr it projects a 19.5% fall. Over the next year, Los Angeles -19.5%, New York -7%, Miami -19.5%.



Composite 25 Index - TRS Rates*

Term Date | Years | Strike (HPA) Ch | Size($MM)

30Sep08 | 1.0 | -11.75 / -9.75 0.25 | 5 x 5

30Sep09 | 2.0 | -10.50 / -8.50 0.17 | 5 x 5

30Sep10 | 3.0 | -9.00 / -7.00 0.00 | 5 x 5

30Sep11 | 4.0 | -6.50 / -4.50 -0.17 | 5 x 5

30Sep12 | 5.0 | -4.75 / -2.75 0.33 | 5 x 5

New York Index - TRS Rates*

30Sep08 | 1.0 | -8.50 / -5.50 0.08 | 5 x 5

Los Angeles Index - TRS Rates*

30Sep08 | 1.0 | -21.00 / -18.00 0.33 | 5 x 5

Miami Index - TRS Rates*

30Sep08 | 1.0 | -21.00 / -18.00 -0.17 | 5 x 5



Contract pays Notional x (Quarterly return on index - Fixed rate/4 )



Now, these are not always unbiased predictors of index values, as some banks/brokers may use them to hedge their illiquid mortgage books (e.g. if you expect that you REO portfolio will grow by $20m next year in LA, you may want to hedge yourself against home price depreciation in LA by selling the index).



But at least this is a market where people put their money where their mouth is, unlike the CNBC "gurus".
 
to explain the table:

30Sep09 | 2.0 | -10.50 / -8.50 0.17 | 5 x 5



30Sep09 = property index change between Sep 07 and Sep 09

2.0 = 2yr (=2009-2007)

-10.50 = if you want to pay the index, i.e. you are betting that house prices depreciate, you will receive negative 10.50% annual rate, so house prices need to fall by more (per year) for you to make money,

-8.50 - if you want to receive the index, you will pay negative 8.50% rate, so house prices need to fall by less than 8.5 for you to make money.

0.17 is the change since yesterday (small)

5 x 5 = 5 million bid and 5m offer = the size in which you can do these trades with this particular dealer.



It is typical to take the middle (-9.5 in this case) as the likely expectation.



Note that over 3yrs, national prices are projected to fall 24% (8% per year middle, over 3yrs)



The index is supplied by Radar Logic, based in price per sq ft of actual sales.
 
Ok, so one of the dealers is quoting 3yr LA swaps as well:

SEP 08 -20.00% / -17.50% 10X10

SEP 09 -17.50% / -13.50% 10X10

SEP 10 -13.75% / -9.25% 10X10



If you take the mid level for 3yrs, -11.5%, it implies cumulative 31% drop.
 
Bid-ask spreads are what they are. This is an illiquid market with a lot of uncertainty about where the prices should be. So the 6 dealers supporting it are taking some non-trivial risk by making prices. The flows are sparse, so if a large bank sells the index to hedge its expected foreclosures, the dealer is likely to keep this risk until maturity without being able to unload it to someone taking the other side. In the more liquid national index the spreads are tighter.
 
earthbm,

Are you sure of your interpretation of the data? "...it implies cumulative 31% drop." I don't see where you get the 31%.



If I take your figures above and state the mid level: (Assuming I can calculate the average in my head as I write...)



SEP 08 -18.75

SEP 09 -15.50

SEP 10 -11.50



I would interpret these data as saying that between the time of the quote and Sep. 2008, the price of the housing index (and therefore housing) is predicted to drop by 18.75%.

Between the time of the quote, 2007, and Sep. 09, the price of housing would drop by 15.5% (This may be where I go wrong.)

Which would imply a small, 3.25% rise between Sep. 08 and Sep. 09.

Similarly, a small rise between Sep. 09 and Sep 10.



I ain't tellin' I'm just askin' cause this ain't my field of expertise...
 
Nope, those are annualized numbers (because most people in the business think in terms of annual interest rates).



So the 3yr depreciation is = (1 - 0.115)^3-1 = -31%

2yr = (1 - 0.155)^2 - 1

1yr = (1 - 0.1875)^1 -1
 
<p>Carnage in the mortgage market.... Home price index swaps are marked down... Although if this persistes, you won't be able to get a mortgage to take advantage of low prices...</p>

<p>LA probably the hardest hit... Only 1 year is trading, and it projects 23.5% drop in prices ($ per sq ft) from Dec 31 2007 index to Dec 31 2008. 5% lower since last we</p>

<p>



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3/4/2008

-18%







3/6/2008

-18%







3/7/2008

-19%







3/10/2008

-19%







3/12/2008

-19%







3/13/2008

-20%

AM





3/13/2008

-20.5%

PM





3/14/2008

-23.5%









</p>

<p>Not a lot of change in the natiowide index though (compare to above):</p>

<p>



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per year

cumulative





1

-14.00%

-14%





2

-11.75%

-22%





3

-8.25%

-23%





4

-5.75%

-21%





5

-4.25%

-20%







</p>
 
<em>"Although if this persistes, you won't be able to get a mortgage to take advantage of low prices..."</em>





That is exactly why prices will drop so low and cash will be king.
 
<p>Another day of carnage. LA 1yr index is -26.5% now (Dec 07 to Dec 08)</p>

<p>Thats >35% drop from peak. </p>

<p> </p>

<p>As mentioned before, it is probably overstating true price decline expectations, because some of it is risk premium that banks hedging their REO books pay, but still...</p>
 
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