The silver lining

The US property market hasn't exactly been overwhelmed with good news recently. After years of double-digit growth, house prices have all but stalled, with the Office of Federal Housing Enterprise Oversight reporting that its house price index grew by just 0.5% in the first quarter this year compared with the fourth quarter of 2006 - the slowest growth rate in 10 years. Meanwhile, rising US interest rates have caused delinquencies in the subprime mortgage market to soar as borrowers struggle to meet ballooning loan payments on adjustable-rate mortgages (ARMs). Delinquencies for subprime ARMs reached 15.75% in the first quarter of 2007, compared with 12.02% a year earlier, according to the Mortgage Bankers Association of America.

Still, one area of the market looks set to benefit from this run of bad news-property derivatives. After several, largely unsuccessful, attempts to get a US property derivatives market off the ground, uncertainty over the direction of house prices and concern that the problems in subprime may spread into the Alt-A mortgage market (a categorisation that falls between prime and subprime) - and perhaps into the prime market too - could be the catalyst the market needs.

"The subprime market has brought a lot of attention to property derivatives, and at some point that will be converted into real trades. Falling property prices have resulted in increased enquiries on trades for specific locations," says Rajiv Kamilla, head of exotic structured products trading at Goldman Sachs in New York.

Certainly, the market's potential is huge. Real estate is the single largest asset class in the US, with the residential property market worth in the region of $20 trillion-23 trillion and the value of commercial property standing at around $5.3 trillion. "Even if derivatives trades amount to only a small subsection of that, the market's potential is still huge," adds Kamilla.

So far, most of the effort has focused on the exchange-traded market. In May 2006, the Chicago Mercantile Exchange (CME) launched futures and options contracts linked to the S&P/Case-Shiller Indexes - a suite of indexes that track residential house prices across the US. The CME has contracts on 10 city indexes (Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York City, San Diego, San Francisco and Washington, DC) and one composite index. The indexes use the repeat sales pricing technique to measure housing markets, which involves collecting data on single-family home resales.

However, the contracts have not seen huge trading activity. Just 186 housing futures contracts traded in July, compared with 464 in July 2006. Mary Haffenberg, associate director, product communications at the CME, says this is in line with the exchange's expectations. "It is a brand new product and, as with the launches of most of our products, there is an education process that has to take place before the contracts can really grow."

Nonetheless, some claim the design of the product has held the market back. In particular, the contracts currently only go out to one year - but most firms want to protect themselves for longer periods of time. This is an issue that will be addressed this month, with the CME extending its contracts on the S&P/Case-Shiller index out to 60 months from September 17. The exchange said this move was in response to customer requests.

More recently, exchanges have looked to introduce contracts that give investors exposure to commercial real estate. The CME, for instance, is developing futures and options contracts based on the S&P/GRA commercial real estate indexes, expected to be launched within the next three to nine months. The indexes have been developed by S&P and California-based real estate and investment research group GRA, and track transaction-based price changes in various regions and sectors. The index series will include 10 commercial real estate indexes: a composite, five geographic regions and four national property sectors.

Meanwhile, the New York-based International Securities Exchange (ISE) has launched a derivatives market linked to the ReXX commercial real estate property indexes - a suite of indexes based on asking rents and lease transaction prices, interest rates and inflationary indicators. The property derivatives market operates using the ISE's Longitude framework, a mutualised matching engine. For each index offered, a series of auctions are held prior to publishing date of the ReXX index, which allows market participants to trade digital and vanilla options, as well as forward contracts on the index value. This was launched in November 2006.

While the market for residential property derivatives includes retail investors, the majority of interest in commercial real estate is likely to be from professional investors. "The US housing and commercial real estate derivatives markets have professional, dealer, investor and retail support," says Fritz Siebel, director for US property derivatives at interdealer broker Tradition Financial Services (TFS) in New York. "Investors are still learning about the products. US housing derivatives have a wide range of users, including retail, while US commercial property derivatives is still mostly inter-dealer."

The fact the commercial property market is dominated by dealers would suggest there is potential for a burgeoning over-the-counter market, enabling users to trade tailored, bespoke transactions. However, only a handful of OTC trades have been executed in the US so far, in sharp contrast to the predominantly OTC-focused UK market. According to London-based property research company Investment Property Databank, the UK market has grown from approximately £260 million in 2004 to £7.27 billion in outstanding trades at the end of the second quarter of 2007.

One of the main obstacles to the growth of the OTC commercial property derivatives market is that, until relatively recently, only one bank - Credit Suisse - was licensed to use the NCREIF property index, a long-established commercial real estate index controlled by the National Council of Real Estate Investment Fiduciaries.

That is now changing. In March, a further six dealers were granted licences to trade the NCREIF property index - Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley and Pierce, Fenner and Smith Incorporated. More are likely to follow and dealers, in turn, expect more OTC commercial property trades to be executed.

In fact, dealers and brokers say there are plenty of investors keen to gain exposure to the property market, but have typically done so through indirect means. "Hedge funds and other sophisticated financial players are currently indirectly trading synthetically on the residential and commercial property markets via inflation and fixed-income derivatives, such as the 10-year US government note, but this is tenuous correlation at best. People have tried to trade the property markets in many different ways, but now there are actual products available. With these new products, there will be new hedge funds dedicated to trading in them," explains Phil Barker, US head of property derivatives at GFI in New York.

As the OTC market grows in liquidity, these investors, along with new, specialist property funds, could start to enter the property derivatives market, continues Barker: "Morley and CBRE Reech Aim have started to trade in the UK, European and global markets, and in the US, there has been talk of other funds starting up in the near future."

Over-the-counter trades in residential property are also starting to emerge. At the end of last year, Goldman Sachs announced it was building a residential property derivatives team (Risk November 2006, page 14) and has executed a handful of trades so far, says Kamilla. "On the residential side, we have done a few trades and continue to have discussions with interested parties - there is a lot of interest. On the commercial side, we have also done trades facing other broker-dealers and end-users. Individual trades in both the residential and commercial sectors have typically had a notional value of $5 million-10 million. The tenor on the residential side has tended to be three to five years, and two to three years on the commercial side," he says.

GFI has also been involved in several trades, reveals Barker. "We have already structured some long-term residential deals based on the Case-Shiller index. We structured a deal with Goldman Sachs for a five-year transaction that protected the customer from downside exposure in the US housing market, as measured by the Case-Shiller index."

The firm also brokered another trade, which gave one party exposure to the NCREIF property index in exchange for Libor plus 310 basis points. The two-year trade has a notional value of $10 million. "This was executed on behalf of two international banks earlier in the year," adds Barker.

As well as giving users a direct means of taking exposure to or hedging real estate, property derivatives could be embedded into mortgages, say dealers. "The growth of the property derivatives market will enable lenders to offer loan products that include embedded price protection on the underlying property or mortgage loans where rates are indexed to property prices. Lenders will then be able to hedge their property price exposure in the capital markets," says Kamilla.

Barker also expects property derivatives to open up a wider array of trading opportunities, beyond simply going long or short property. "At the moment, commercial mortgages have interest rates capped through interest rate derivatives, but lenders could also insist on adding protection to the equity in the property. We are seeing this concept develop in the subprime market," he explains. For instance, mortgage banks may lend at more attractive rates for those borrowers with derivatives protecting their exposure.

Certainly, the size of the underlying US mortgage market means there is a broader universe of trading strategies than could be employed in the UK or Europe, continues Barker. "Because the US has a bigger underlying market than the UK, we are expecting more interesting trades and deals to be created. A commercial mortgage-backed securities (CMBS) market has only just started in the UK, whereas in the US, the CMBS market is already well established, which means there is already an established debt side. Property derivatives will provide the means to arbitrage into equity. For example, there should be correlation between the performance of real estate debt and real estate equity. If there are liquid markets for both debt (CMBS) and equity (property derivatives), there are arbitrage opportunities available in the market, as well as trading strategies that were not available before."

Meanwhile, the publication of standardised documentation for OTC property derivatives in May has eliminated some of the uncertainties involved in trading the market and could encourage more firms to use derivatives. The International Swaps and Derivatives Association property index derivatives definitions are intended for use in confirmations of individual property index derivatives transactions governed by other Isda agreements.

"The Isda 2007 property index derivatives definitions will increase efficiency, reduce legal risk and improve liquidity in a relatively small but rapidly growing segment of the privately negotiated derivatives business," says New York-based Bob Pickel, executive director and chief executive of Isda.

In conjunction with the release of the definitions, the association also published new confirmation forms for common types of property index derivatives transactions, including total return swaps and forwards. An options confirmation template is also being developed.

Property derivatives may have been tried plenty of times before - in fact, Robert Shiller, a professor at Yale and co-creator of the Case-Shiller indexes, pitched the idea to the Chicago Board Options Exchange as early as 1993. This time, however, dealers appear to be optimistic that there's a good chance the product could get off the ground.

"The value of the US residential and commercial real estate markets approaches $30 trillion, the single biggest asset class in the US. As these markets find the best frameworks for real estate derivatives trading, liquidity will rise and relevance will grow," says Siebel of TFS. "We are finding that there is a great deal of institutional interest from abroad for these products - the real estate derivatives complex provides low cost, immediate access to US housing and commercial property. Pension funds and asset managers are following the development of these markets with interest."

Anuszka Mogford