The Blackwell Companion to the Economics of Housing: The Housing Wealth of Nations edited by Susan J. Smith and Beverley A. Searle, chapter 21, forthcoming, 2010. Trading on house price risk Index derivatives and home equity insurance Peter Englund Stockholm School of Economics and University of Amsterdam Recent developments of public sector welfare systems and financial markets offer new incentives as well as new opportunities for households to make active financial decisions. New financial instruments and better functioning markets facilitate hedging health and income risks. The well informed and rational individual can now actively trade off risk against expected returns. Still some of the major risks in life remain difficult to affect, those associated with housing choices being perhaps the most conspicuous example. For most households buying their home is the major investment in life and the home is the major asset in the wealth portfolio of most households. But this is an investment driven by consumption motives rather than by risk-and-return considerations. Households choose to own because the ownership market offers them more flexibility of choice and because owning solves some basic agency problems that are not well handled by a rental contract. Households choose the amount of housing investment out of consumption needs rather than by thinking about optimal portfolio composition. As a result many households end up with very unbalanced portfolios with several hundred percent of their net wealth invested in real estate. While this might be optimal from a risk-and-return perspective for some households, it is certainly not universally so. Modern financial technology should be useful also for trading in housing risk. In this chapter I will discuss how financial derivatives could be used to enable households to disentangle consumption from investment decisions and to adjust their exposure to housing risk without any consequences for their consumption of housing services. The next section gives a short introduction to the importance of housing in household wealth portfolios. This is followed in section 2 by a characterization of the risk and return properties of housing as an investment object. The following two sections provide a brief analysis, drawing on the recent academic 1 literature, of the potential gains if households could trade in financial instruments related to house price indexes. Finally, section 5 reviews current market experiences and proposals to create new home insurance products and index derivatives markets. Section 6 concludes with a brief discussion of likely future developments. 1. The owned home in household portfolios In economic analysis, we typically distinguish between investment and consumption decisions. For housing, however, these two decisions are intertwined. In principle, they can be disentangled by making the consumption choice through renting housing services and the investment choice by purchasing some form of real estate securities. In practice, most households aspire to own their home for reasons not primarily related to investment returns. In industrialized countries 6 out of 10 households are homeowners. This average conceals large differences across countries, from lows of 30-40 percent in Switzerland and Germany to highs of round 80 percent in Spain and Ireland. In many countries – such as the United States – a high rate of homeownership is an explicit political goal and tax policies and mortgage market institutions are directed at easing access to homeownership. In other countries – like Sweden – stated policy objectives indicate neutrality towards the choice between owning and renting. In practice, transaction costs and the availability and cost of mortgage finance are probably the most important factors explaining the differences in homeownership across countries.1 In many countries the tax deductibility of mortgage interest payments is not fully offset by property taxes or other taxes on the returns to homeownership, whereas the taxation of the rental sector tends to be approximately neutral. In most countries the fraction of homeowners has been increasing in recent decades, largely as a result of improved borrowing opportunities following deregulation and technological innovations in the financial industry. This development has probably been welfare-enhancing by allowing access to homeownership for many low-income households previously locked out from this market by high downpayment requirements. But, as witnessed by the current sub-prime mortgage crisis, it has exposed many of these households to new risks that they are ill-prepared for. 2. How risky is housing? 1 See, e.g., Hilber (2007) for a study of the determinants of ownership rates across Europe. 2 Homeowners are well aware that house prices fluctuate. Under normal conditions this may not be a major concern for current owners, as long as it does not directly affect their housing expenditures. In fact, rising prices may even be seen as bad news insofar as they affect the base for property taxes. House price fluctuations do, however, become of more direct concern for anybody who considers moving from one area to the other, as price movements are often not well coordinated across regions. In fact, it seems that variations in overall housing price levels coincide with variations in relative prices. As one illustration, figure 1 depicts an index of the relative price between a Scotland and a London one-family house. During the two periods (1983-88 and 1996-2002) when house prices in general sky-rocketed in all of the United Kingdom, the London price level doubled relative to that of Scotland. In the years in between, on the other hand, both absolute and relative prices moved in the opposite direction. In 1993 the price of a London home relative to a Scotland home was back at the 1983 level. Clearly, such fluctuations represent substantial risks with an enormous impact on the distribution of life-time resources across households with different patterns of mobility. In order to analyze the riskiness of homeownership in more detail, we need to first discuss how to measure the returns to owning a home. The returns consist of two main components: the capital gains (and losses) and the value of the housing services enjoyed by living in the house (the implicit rent that the homeowner “pays to himself”). The capital gains cannot be observed with any precision until the house is sold and the gains (or losses) are realized. Yet, they make up an important and risky part of returns and to assess the full risks of housing we need to measure the gains per period as they accrue during the holding period. Returns can be measured using (the log difference of) price indexes constructed based on observed transaction prices. In such indexes, the heterogeneous nature of houses is accounted for either by hedonic regressions or by repeat-sales estimates (or with some combination of the two). It is important to emphasize that house price indexes are statistical constructs valid for a representative house. They are not exact measures directly applicable to an individual house, nor do they measure the price and returns of a well defined continuously traded portfolio of properties analogous to, e.g., stock price indexes. Rather, they should be interpreted as measures of the development of expected sales prices for a representative house. There are at least three important differences between a house price index and a stock index that are important to keep in mind when comparing return properties and discussing the viability of various index related derivatives. First, it is not possible to trade directly in the 3 portfolio of properties underlying the house price index. While this problem may not matter for index construction, it is a strong deterring factor in developing a market in index derivatives. Second, house price indexes are always measured with error. Third, the returns as indicated by price index changes do not account for the idiosyncratic risk associated with an individual house due to unique characteristics of the house as well as the special nature of the transaction when a house is traded. The other component of returns, the implicit rent, is also fraught with measurement problems. The natural approach would seem to be to use market rents, in which case the measurement problems would “only” be those related to the heterogeneity of dwellings, i.e. in principle the same problems as with price indexes. Unfortunately, rent indexes have the added problem that rental markets are often regulated or otherwise poorly functioning. In fact, they may be close to non-existent for one-family houses in many countries. Furthermore, even in unregulated rental markets observed rent variations are restricted by long-term contracts, and fluctuations in vacancies is an important equilibrating mechanism. In practical calculations of housing returns, implicit rents are often measured by simple rules of thumb, such as a fixed percentage of market prices. As a result, the variability of housing returns is likely to be understated. This may not be too serious, however, since the “cap rate” that translates prices into implicit rents is likely to have a low variance relative to the capital-gains component of housing returns. In terms of providing inputs to a portfolio choice problem, it is probably more problematic that the level of rents, and hence expected returns, is based on such ad hoc assumptions. Bearing these caveats in mind, a number of authors – e.g. Goetzmann (1993), Flavin and Yamashita (2002) for the U.S., Englund, Hwang and Quigley (2002) for Stockholm, Iacoviello and Ortalo-Magné (2003) for London, and le Blanc and Lagarenne (2004) for Paris have computed the means and variances of housing returns. Generally speaking, they all find that housing is an average asset with mean returns and variance higher than for bonds but lower than for stocks. Estimates of mean return vary quite a bit across studies, however, partly reflecting the particular sample period.