Weighing up the risk of property price fluctuations

15 March 2010

A residential property derivative is a bilateral wager similar in concept to spread betting, based on how much Halifax’s house price index will move up or down over a predetermined time period. For example, a contract might be struck at 10% with a maturity date of June 2012.

This would mean that the buyer of the contract receives payment if house prices go up by more than 10% and the seller receives payment if they go up by less than 10% or even fall. These contracts are typically used by firms wanting to reduce their exposure to the property market in a process known as hedging.

Mortgage lenders often suffer if house prices fall. They may sell property derivatives so that any gain offsets the loss on their mortgage books if prices fall.

But it’s difficult to work out how much to sell. If a lender has a book of £100m of performing mortgages with an average LTV of 75%, how much hedging should it do? And clearly, it will need to increase the hedge amount if the LTV is 95%.

To quantify the amount of hedging required lenders may need complicated econometric forecasting models that can predict loan losses in a variety of house price scenarios.

Econometric models are widely used in the US mortgage market but are less common in the UK, although many lenders here have already had to address similar issues for stress testing purposes.

Lenders need complex forecasting models to quantify the amount of hedging required

We have developed such models for use in many jurisdictions.

If a lender has forecast losses of £10m if house prices drop 50% by June 2012 this means it could consider selling £20m worth of derivatives at the current index level.

If house prices are 50% lower in June 2012 it will receive a payment of £10m - £20m x 50% - which will offset its loan losses.

Sounds too simple? Well, the reality is that any loan book’s performance will also be driven by other factors such as interest rates.

Also, if property prices go up by 50% the lender in the example above would have to make a payment of £10m under the terms of the derivative.

But on the other hand it might not make much profit on its loan book and so suffer a net loss.

So are residential property derivatives worth the paper they are written on? I believe so.

Interest rate derivatives are a useful tool for risk management and mortgage lenders will increasingly look to property derivatives as a hedging tool for property price risk. In fact, they are one of the few options available to these firms right now.

The views and opinions expressed above reflect those of the author and do not necessarily reflect the views and opinions of Citadel Investment Group LLC or its affiliates.