This week’s Economist has an article about the possible emergence of a market in house-price hedging derivatives. It’s at Housing Derivatives: Spark of Invention and appalls me. Appalls not least because the writer seems to genuinely believe that it’s a great idea. Still hungover and bleary eyed from the last economic piss-up, we’re already planning the next one.
The article starts off by comparing house fire insurance with the idea of house-price hedging. That’s very unreasonable. The business model behind insurance is not a zero-sum game. The execution of that model by many insurance companies in recent times (AIG to mention just the best known offender) may be ridiculous, but the basic model is sound: based upon actuarial risk, a large group pool resources to pay out to the few when something happens. If the actuaries are good at their job everyone is happy: the many who required no payout, the few who did and the insurance company who retain a profit. Maybe difficult to achieve, but sound in principle.
What is being describe in this article, however, is a different beast altogether.
The best summary of it is this quote from the article itself:
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.
We start off well, using the word “bet”, but then fall flat. That last sentence should read: “That means every bet has an opposing bet.” Part of what has got the world into its current economic mess is the very act of thinking that bets can be investments. Bets are just that: bets. Fun on the gee-gees. Splendid at the roulette table. Not a basis for ensuring a roof over your head.
It’s as if the last few years didn’t happen. Look: free money! Buy a house and you can’t lose! If the price goes up, you make money! If the price goes down, you make money! Ain’t life grand?
All this overlooks that such an instrument is, unlike insurance, just another zero-sum game. In many such situations, the players at least have the decency to take opposing views: I think it will rain today, you think it will not rain today. There’s at least some rational behaviour on display. But what will happen here? I buy a house and bet, via this technique, that while I think the value will not go down I’m covered in case it does. And the counter-party? The counter-party will be a financial institution, a bank, who also believes that prices will not go down in the longer term. Win – win! And, also, the small fact that it’s not just my house that has lost 20% of its value. This is not the “my house burned down but everyone else still has one” situation. If my house value falls, so does that of everyone else. All our houses, across the country, have burned down.
It would, of course, be possible to offer true insurance policies that would safeguard the value of your property. As per above, with the appropriate analysis and pricing, anything can be insured against in an economically rational manner. But it will never happen on a large scale due to the immense cost to the policyholder. It’s too expensive. And therein lies the very essence of why this concept of house-price derivatives is so wrong: it’s a free lunch. And as we all know… etc.
The article finishes up by suggesting that “…the only obstacle to widespread adoption is a deep-rooted belief that home prices always increase.” Oh how I wish that were true. The really frightening thing is that that deep-rooted belief, however misguided it is, will be the very thing that encourages such a model to flourish. Flourish until the emperor notices, once again, that he’s butt naked. And homeless.
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