Don’t put your eggs in one basket

With a dull thud, my university alumni magazine lands. It stays in its cellophane wrapper for days until, eventually, I get around to flicking through it. Then, amid the articles about ex-student’s memories (funny how they never quote the person who was thoroughly miserable) and offers to cruise the Aegean and rent houses in Tuscany, one leaps out.

It’s an interview with the academic Professor Susan J Smith (she inserts the J, she says, because in a world dominated by Google she has to — I rather like that) in which she extolls the virtues of housing derivatives.

This is an oft-touted idea but one that’s been notably absent of late — not least because of the dreadful association of the word ‘housing’ and ‘derivatives’. After all, it was derivatives based on housing of the sub-prime kind that brought the world’s banking system to the brink of meltdown.

So to see the good professor flying the flag again is startling. But to be fair to Professor Smith, the financial instruments she is talking about are not those that were based on bundles of loans to down-at-heel borrowers in America’s mid-west and then traded by speculators across the world, but a route to affording more security to homeowners.

Safe bet

The Smith thesis is that we tend to regard property as a sound bet, hence the phrase as ‘safe as houses’. To that end, we pour into our home a considerable chunk of our income — in fact, for many people the biggest purchase they ever make in their lives will be their home. We do so on the basis that property prices will increase and we will get a return for our money.

But what if that does not happen? We’ve done nothing to hedge our investment, to protect ourselves, and we lose. In no other walk of life where major sums are changing hands and livelihoods are dependent on the outcome is that allowed to occur. Potato farmers will take out an option against prices falling. Likewise, pork producers will insure themselves against pork belly prices plummeting. You name it — in commodities, metals, bonds, the list goes on — there are derivatives available covering movements in the market. Not so for houses.

Derivatives trading is a $450 trillion industry but it doesn’t include the biggest asset of all: residential property. Of course, there’s straight insurance if a house burns down or suffers from subsidence. But there is no way of protecting against a drop in the value of the house. No ability either, to free the equity tied up in the property.

Home buyers are given just one option. They must buy both the property and the services that go with it — the ability to live in the house. And they must also purchase the investment vehicle that accompanies it — the up and down movements in its price.

Elsewhere, financial engineers are used to separating the latter from the former, to dividing the returns from the physical asset. But not in housing so far. ‘The most interesting thing about derivatives, where housing is concerned, is that you can use them to manage the investment risks associated with owner-occupation,’ Professor Smith tells Cam magazine. Smith, who is also the new head of Girton College, Cambridge, goes on: ‘Everyone needs to pay for some kind of housing service, whether they buy or rent. And as a buyer, I feel fantastic because I’ve got an appreciating asset. But it also means I’ve got all my money tied up in the fortunes of one property in one place. As an investment strategy it’s on a par with sinking all your money into a single baked bean factory in East Anglia.’

Spread the risk

What is required is the development of a house pricing index. It’s been much discussed but has never properly got off the ground — not to the point where it occupies the same place in the public consciousness as the FTSE share index or the currency rates for instance. Housing derivatives would be based on the performance of such an index. Rather than bet on their own property increasing in value, investors could take a wider punt, spreading their risk.

They could take a chance on prices rising or they could sell short - insulate themselves against prices falling. Where it gets especially interesting is that Professor Smith argues that the popular use of such an index and the various associated derivatives that would flow from it, could create more affordable housing. A first-time buyer, for example, who could not sustain their mortgage repayments could sell off a portion of their future profit in return for a lump sum to enable them to meet their mortgage arrears.

‘It could also be used to promote labour mobility, as people would be less worried about returning to London, say, if they relocated elsewhere; and these instruments potentially make it much easier for older homeowners to release cash from their property to supplement retirement,’ she says.

A shield of comfort

The weakness with Professor Smith’s proposal is that derivatives is such a derided, reviled word, especially now. ‘Financial weapons of mass destruction’, as legendary US investor Warren Buffett termed them.

Already, she points out, people are tending to prefer the use of the less inflammatory ‘financial instruments’. But that doesn’t mask the truth: what she is suggesting is a class of derivatives based upon housing. ‘There is a problem there and it’s not new. In 2000, for example, there was a big shock precisely because people were starting to develop credit derivatives that were too complicated and mysterious even for the people who designed them,’ she says. ‘But derivatives don’t have to be complicated. And they don’t have to be unregulated or developed and used in a self-serving way.’

To my mind, what Professor Smith is advocating makes perfect sense. On one hand, it is possible to get hung up about derivatives and the dangers they pose. On the other, the risk the homeowner carries is far worse. Yes, derivatives can be a source of speculation but they can also, if treated wisely, afford a shield of comfort. The professor merits taking seriously.

Chris Blackhurst is city editor of the London Evening Standard