Hedging Financial Risk For First Time Homebuyers?

A few people in Seattle have asked me if this is the right time to buy a house. They don’t really want my answer. They want to buy and want me to agree with that decision. My needs and their needs are not the same. My goal (at this time) is to maximize investment, not to be a homeowner.

One lady I know is tired of moving. She wants to have children and wants her own house. I’m a single guy with no debt. My plan is to wait it out and buy a kick-ass place at the bottom. She has a biological clock that can’t be reconciled with inventory levels. She needs to buy a house in order for her to be comfortable with being a new mother.

I started mentioning to her how sophisticated investors could hedge risk by trading Case-Shiller futures on the Chicago Mercantile Exchange. Too difficult. Robert Shiller mentioned in Irrational Exuberance how someday regular home buyers would be able to purchase insurance to protect themselves against home price declines. However, that day hasn’t arrived yet.

There are some financially smart people who read this blog. Do you have any ideas on how a first time home buyer could hedge against the risk that their home might drop by 20% in value in less than 5 years? There has to be a way the average Joe can easily offset some of the risk associated with the largest purchase they will ever make.


Add yours

  1. I agree that the last thing we need is a bunch of non financial savvy people trading the case-shiller futures to hedge their new house purchases. The best way for someone who is absolutely intent on hedging their home purchase is to connect with a full service futures broker who will advice them on exactly what to buy. The fees will be hefty, but compared to the real estate commissions it will be peanuts. Im sure that someday we will probably have easy ways (case shiller ETF’s) for the average guy to hedge the impending collapse in his home value, but that day is not now.

    The best move, of course, is to practice a little patience and sit out the continued housing collapse. At the very least, wait until the incompetent members of congress pass all the ridiculous tax payer funded builder bailout and homebuyer credit incentives to purchase a new home.

  2. Have a trust of which you are the beneficiary purchase a credit default swap on your own loan note.

    Just take out an insurance policy that covers fire… accidents happen all the time.

  3. I really want to argue here against treating a home purchase as an investment. But I’ll set that aside for now.

    The best hedge a new home buyer could use against a 20% drop in the first 5 years of ownership is to make sure they apply at least a 20% down payment on their purchase. The good (?) news is that in order to qualify for a mortgage now you’ll probably need to provide just such a down payment!

  4. Yeah I agree that a home shouldn’t be viewed as an investment, but the reality is that people do move more frequently that they anticipate and for the last few years annual price swings have been extreme.

    Once the dust settles in a few years, I think the “home as an investment” idea will return to a more normal historical perspective. Until then – you can’t ignore huge inventories and tighter lending will continue to force prices downward.

    The only idea I can think of is to buy an Inverse ETF against Commercial Real Estate (SRS), since it tends to lag Residential Real Estate by 18 months. Not true hedging though unless LEAP options are purchased.

  5. I’m wondering about something a bit more straightfoward such as an insurance contract. Think of PMI except in this instance it actually protects the buyer and not the lender. How would such a contract be written and how would the terms be enforced? Would the homeowner need to be defaulting in order to make a ‘claim’ on this contract or could you use it during the course of any sale in a certain time period. How much would it cost and would any home buyers really buy it?

    It smells like something that could be very profitable to sell in the current market environment. But I’m guessing it’s the type of thing few consumers would be willing to buy 5, 10, or 20 years down the road once the market is stabilized and the housing crunch is little but a fuzzy memory.

  6. Shiller’s vision would be to first develop metro markets that monitor price levels (like and S&P 500). He did that after the publication of the book. The index is very new.

    The 2nd step is offer a way to trade futures on that index. Now you can do that on the CME.

    Step 3 is for someone to come in and repackage that risk into insurance form.

    Collecting on the insurance wouldn’t require a default, just poor market conditions at the time your property went for sale.

    That insurance may not appeal to the homeowner, but in an unstable market, would appeal to the lender. If they lend $100M out in Vegas and that market takes a dive, they get their defaults, but they offset those losses with their insurance (options against the Case-Shiller futures).

  7. When you are not making money on something, it is not an asset — it is a liability. When you are living in your home and making mortgage payments it is a liability, not an asset/investment. If you move out and rent it out for positive cash flow, it is an investment. So, your home you live in is not an investment.

    Now that we have that cleared up, if one was absolutely convinced to buy a home now, here’s what I would suggest:

    1 – You plan on living in it a very long time (7-10+ years)
    2 – Your financing structure should be very conventional and match your plan above. Get a loan with 20-25% down (can you afford that much?), fixed rate for 30 years with principal and interest payments (30 yr amort of course, more if you can get but doubtful) with monthly payments that are not intimidating (with escrows).

    And, of course, be an absolute bull dog at the negotiating table – if you aren’t getting it for at least 70% of FMV (fair market value – make sure your comps are ACTUAL sales in the last six months within 0.5 miles of your property depending on your area and that the comps are really tight: same bed/bath mix, age, size, etc) then move on. Better yet, try to get an owner financing deal or perhaps a lease purchase deal(make sure your rent credits are high and your option/strike price is very conservative/low) or ideally a subject to deal. Make sure it’s a newer house in a great neighborhood and be extremely anal retentive with your inspection (demand maintenance records).

    I’m a former full time residential investor and currently a full time commercial investor with a little bit of money, and I’m renting the home I live in right now so no shame indeed (although I’d buy a nice home if it was an absolutely kick ass deal and the underlying financing was cheap and long term).


  8. Good advice MATT.

  9. The hedge is to only purchase a home because you intend to make a it a home in the long term. 5 years is not the long term.

    As a negative net worth, non-house-owning person, the conditions under which I would buy a house are a) buy with cash (unrealistic for probably the next 10 years for me and my wife) or b) a 15 year fixed loan that I would be able to aggressively pay ASAP (possible maybe in another 6 years for me).

    So it comes down to being ready for home ownership — which means no debt going in, big down payment, and in it for ownership over the long haul. If I’m happy with the deal at the time of purchase, then why would I *not* be happy with it even if my home is suddenly worth less according to zillow.com? I got into the deal because I thought it was a good deal.

    As I reread what I just wrote, I see that I’ve internalized the basic Dave Ramsey advice on this subject.

  10. After adjustment for inflation I don’t think homes will EVER be this high again, so the amount of time you hold it may not matter.

    Also, any amount of mortgage payment above what you could rent it for is an investment. If you want to catch a “falling knife” now then you are paying a premium on a depreciating asset. This is generally a bad idea.

    Further, the more you put down the more you will lose. 20% down is 4:1 leverage which is great when prices are rising …not so hot when they are dropping.

    In addition, if you live in Seattle don’t believe the hype that “it’s different here!” We are about 12-18 months behind other markets, but we peaked and are headed down like everyone else. The best explanation I heard is that many businesses here make money from other businesses (i.e. MS, Boeing), so there is a lag. Seems plausible, but I don’t really know why …just that there is a lag.

    Finally, double-shorts seem like a pretty good hedge although they are obviously a different asset class and have different influences on their price. IYR is the 2*short REIT Index, but it’s kind of flacky. I would just wait for this bear rally to peak and start buying into double shorts. I think both housing AND equities have a long way to the bottom still.

    Anyway, that’s my 2 cents…

  11. Final note: Remember around 2003 when everyone was completely sick of stocks and had ABSOLUTELY no interest in buying them? That’s true capitulation.

    When no one wants to buy a house anymore because they think it is the worst investment in the world …that’s when you start buying property again!

  12. Correction:

    SRS is the 2*Short REIT.

    IYR matches the REIT index (1 * Long)

  13. Thanks Jim.

    I agree that people here in Seattle think they are immune to a real estate correction. This past year in Seattle feels a lot like 2006 felt in San Diego. Like a roller coaster where only the front car has crested.

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