From the July 2006 issue of Wealth Manager Web • Subscribe!

Property Management

Financial engineering is entering middle age, but its impact on investing is only just beginning.

That's good news for those who embrace the expanding array of securities targeting formerly untradeable risk factors. But not everyone thinks the trend represents progress. The new instruments invite speculation and introduce new and bigger hazards into the financial system and the economy, warn the skeptics. The growth of the derivatives market is particularly troubling for those who argue that the calamity unleashed by the implosion of the infamous Long Term Capital Management hedge fund in 1998 was but a taste of things to come as financial engineering blossoms.

Certainly the rise in derivatives trading is astonishing, having grown nearly 300 percent over the past five years to more than $100 trillion by 2005's close--based on the notional value of futures, exchange-traded options, over-the-counter options, forwards and swaps, according to the Treasury Department's Office of the Comptroller of the Currency. That's nearly eight times more than the output of the U.S. economy. Talk about the tail wagging the dog.

But derivatives arguably are a necessity in the global economy of the 21st century. There's no choice other than actively navigating the choppy waters of the capital markets by utilizing leading edge tools that deliver more power into the hands of money managers.

The financial industry has been eager to assist, rolling out an ever more sophisticated menu of choice. The new breed of exchange-traded and mutual funds provides the obvious examples of late. Whether you're looking for long exposure to currencies, oil or gold, or a leveraged-short exposure to bonds ands stocks, such formerly exotic betas are now just a computer click away.

And the list keeps growing. As usual, a peek into the future of finance can be found in the institutional marketplace, which frequently receives the cutting-edge products before they filter down to the masses. Among the suppliers of such new-fangled products is the Chicago Mercantile Exchange (CME), which lists weather derivatives and last year launched several exchange-listed economic products that target such data series as U.S. gross domestic product, non-farm payrolls, and America's international trade balance. Earlier this year, CME rolled out a series of futures and options on housing indices, effectively securitizing a marketplace that previously was available only through direct ownership or private partnerships.

The incentive for buying or shorting such things as the U.S. economy or the American housing market is hardly new. But such trades have been limited to indirect transactions by way of Treasury bonds, for instance. Thanks to financial engineering, such variables are increasingly traded directly.

Although the trading in the new CME derivatives is primarily an institutional market, it wouldn't be out of the norm to see comparable exposures available to a wider audience in the years ahead. Meantime, institutions remain stewards of other people's money. Financial engineering, as a result, affects everyone's portfolio eventually.

What are the implications? For some thoughts about what it all means, we recently talked with Felix Carabello, director of CME's alternative investment products.

What's the relevance of the CME's economic derivatives?

They're based on economic numbers that reflect economic activity. Non-farm payrolls, housing starts, gross domestic product, and so on. There are seven economic derivatives series in all. Traditionally, investors wait for the numbers to be published to get a gauge on the economy. Investors then hedge or take on risk, depending on what the numbers report. You could be right on the number, and the market moves against you. But the economic numbers are being commoditized. With CME derivatives, you're able to express your view on the outcome of the number before it's released, by either taking on exposure or hedging it. That's in contrast to the old way of waiting for the impact on the traditional securities markets.

So, investors can trade on various aspects of the economy directly, rather than doing it second-hand and after-the-fact by selling or buying stocks and bonds.

Right. There's a growing interest in what's considered non-traditional commodities--like weather or economic derivatives. Housing is another one.

Your housing derivatives were launched this past spring. Why does the world need another way to play the housing market?

Housing has long been looked at for its utility value as a home, as shelter. Now, because it's increasingly viewed as a wealth-creation asset, there's a desire to hedge some of the downside risk. There's also a demand for speculation in housing in general.

The major players in the market for CME's housing and economic derivatives are institutional, correct?

Yes. Banks, hedge funds, pension funds, etc.

What choices are available in the new housing derivatives?

The indices are based on cities. Initially, there are 10 major cities, including New York, L.A., Las Vegas, Miami, Washington, D.C. There's also a national index.

What new money-management opportunities are created with housing derivatives?

There are three major asset classes in the United States: The equity market is something on the order of a $15 trillion market. The fixed-income market... is a $24 trillion market. And there's housing, which is roughly a $21 trillion market, but one that traditionally has no means for hedging. Stocks and bonds have instruments that allow you to either hedge or extract value from the marketplace. Housing doesn't have that--until now. With the advent of the underlying housing indices and the associated CME derivatives, our new products add a whole new dimension to the housing industry. They will redefine how housing markets are looked at and traded.

How so?

With the increase of home values in the United States, we've seen an increase in speculation in physical property. The problem is that when you're long a physical asset, and you want to sell it, you have to find the other side of the trade. You have to find someone who likes your home and likes the price. But then you invite all of the entanglements that come with owning physical property. The new indices allow you to buy or sell property values more efficiently.

If you wanted to go long housing values in the New York metro area, for example, you can simply buy the New York index on the CME. Meanwhile, if you think L.A.'s overvalued, you can sell the L.A. index.

These indices will definitely reshape the way investors look at real estate and some of the other instruments tied into housing, such as interest-rate products. In fact, mortgage-backed securities traders have expressed a high degree of interest in the housing derivatives. It's not exactly clear how they're going to reshape the mortgage-backed industry, but the housing derivatives provide a new and different set of data points that will become another leading indicator for housing values.

What exactly do the housing derivatives represent?

First of all, I should note that the underlying benchmarks are the S&P/Case-Shiller Home Price Indices, and were developed by economics professors Karl Case of Wellesley and Robert Shiller of Yale. When you buy one of the indices, you're buying a contract that reflects the value of housing in a given region, or the United States overall in the case of the national index. The underlying values are based on sales. So when there's a transaction, typically it gets reported in the county clerk's office. In turn, that's picked up in the home-price database that collects the information from the transactions, which are limited to so-called arms-length transactions. So, for example, if you bought your house from your grandfather for a dollar, they'd kick out the transaction from the database. The reason is that they're looking for transactions that reflect the difference of the previous sale. So, consider a house that previously sold for, say, $500,000 and recently sold for $700,000--the index would capture that $200,000 difference, and the difference is reflected in the index.

The contracts are settled on a cash basis. No one's going to have to take delivery of a housing development.

Right. If you buy an index, you're not going to take physical delivery of a house. Rather, what the index does is reflect the value of homes in a given region. If you buy the index at 100, and two months later the index is revalued at 105, you've seen a profit of five points. All the contracts do is allow you to express your view, up or down. At the end of the day, you're getting the difference between where you got in and where you got out, and that will determine what you made or lost.

Commodities have evolved from contracts trading physically delivered consumable items--the traditional way the market's viewed commodities. From there we've moved into cash-settled financial instruments, and now we're trading on events--events that you don't really see and that you don't take delivery of. But these events certainly drive economic activity. Take weather, for example, which is also available as contracts on the CME. If it's cold, you'll be inspired to consume certain goods and services and uninspired with respect to others. Meanwhile, if housing values are going down, then certainly you're going to make adjustments in your buying patterns. And if housing values are going up, you may feel free to make more purchases.

What's the life span of your housing contracts?

We started with quarterly expirations. Eventually, depending on how the market unfolds, we'll move into monthly expirations, too. At some point, we hope to have contracts that list out a few years.

What are some of the potential uses for housing derivatives?

Interest from the institutional community has been overwhelming. Some of the bigger institutions want to diversify their portfolios. They want real estate risk in their portfolio. My understanding is that real estate is a non-correlating asset class relative to fixed-income and equities. So, housing certainly has portfolio appeal. Meanwhile, some homebuilders want to sell forward homes that they're building.

Just as a farmer might sell forward corn and thereby transfer the price risk to speculators?

Correct.

Is it as easy to go short housing futures as to go long?

Yes, just like with any traditional futures contracts. There are some folks out there who want to be long real estate, but there are some who feel that, with interest rates going up, home values may start to cool.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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