Bridgeman

Hothouse of financial innovation

FIRE insurance was not given much thought until the Great Fire of London alerted people to the danger of combining dozy bakers and wooden houses. It took two world wars for life insurance to take root. Some think that the housing meltdown is poised to be a similar catalyst for derivatives that allow investors to hedge against movements in the price of residential property.

Housing derivatives first appeared in 2006 as futures contracts on the Chicago Mercantile Exchange but were only available to sophisticated investors. In the euphoria of the bubble, builders and developers showed little interest in the idea. Smart investors preferred to make bearish bets via more bespoke instruments. But in June, Robert Shiller and Karl Case, two economists responsible for a widely used gauge of American house-price movements, opened up the market to retail investors with the launch of a product called MacroShares.

Derivatives have a bad name at the moment, but this sort is tame enough. MacroShares are securities that reflect the value of the S&P/Case-Shiller home-price index in ten large urban centres. The securities are issued in pairs, one for investors who wish to bet on the upward movement of house prices, and one for those who think prices will fall. That means every bet has an offsetting investment. Investors must also pay for their interest upfront, eliminating counterparty risks. And unlike actual homes, MacroShares are traded on public exchanges and are therefore liquid.

The idea has merit. For most people, their homes are their largest single investment. Finding a way to hedge that investment makes sense. Falling prices are accentuated in illiquid markets such as residential property. Having some protection against price falls should reduce concerns over paper losses.

The next step is to tie derivatives more tightly to the interests of individual homeowners. MacroShares is already mulling a product tied to specific locations, rather than national house-price movements. A homebuyer in Miami, say, could offset the risk of price decline in the local area with a housing derivative. Lenders could end up wrapping these derivatives into mortgage contracts as a form of home-equity insurance. That would be an improvement over some of their recent offerings.

Although trading in MacroShares has been light so far, Mr Shiller thinks the only obstacle to widespread adoption is a deep-rooted belief that home prices always increase. If ever there were a time for that to weaken, it is now.