Markets against markets

99 times out of 100, I warmly applaud John Kay's articles. Today's the 100th time. He criticizes Robert Shiller's proposal for macro markets:

Too often the speculative motive has tended to overwhelm the risk motive, and active markets have been a source of instability rather than security. As they were in the last financial crisis.

I'm not sure about this.

Let's imagine there had been a big, active, liquid market in house price futures and options in the 00s, as Shiller would like. What would have happened?

We know that, in a market of noise traders and rational investors, prices can overshoot because the smart money doesn't always trade against the stupid money, and might even trade with it (pdf). To this extent, house price derivatives would have been bubble-prone.

But there's another type of trader to consider - those with hedging demand.

Some of these would have gone long of the derivatives. Young people wanting to buy a house in future, or home-owners wanting to trade up, would/should have bought derivatives as a hedge against prices rising out of their reach. But other hedgers would have gone short. These would not only be home-owners planning on trading down but also mortgage lenders seeking a hedge against the falls in house prices that would increase mortgage defaults.

So, how would our market have looked in the mid-00s?

One possibility is that the weight of shorting from hedgers would have been great, and this would have held derivatives prices down. Arbitrage would then have caused physical house prices to be lower. We'd have had less of a housing bubble and hence less of a burst.

Another possibility is that the weight of noise traders - Kay's speculative motive - would have been so great that there would still have been a bubble in both physical houses and derivatives. But so what? If the derivatives had been over-priced in 2006, those mortgage lenders who did short them would have had a huge payout. The financial crisis would thus have been alleviated, as this payout offset losses on mortgages.

These two possibilities suggest that Kay is wrong and Shiller right.

However, there are two other possibilities.

One is that the bubble in derviatives might have been accompanied by counterparty risk. Those who wrongly went long might not have been able to pay the shorters.

The other is that mortgage lenders might not have used derivatives to hedge their exposure - either because they feared counterparty risk or were just over-optimistic.

In both ways, we might still have had a crisis.

I suspect there's no way of telling what would really have happened in this parallel universe. This, though, doesn't mean this thought experiment is useless.Had we had a bubble and crisis with such derivatives, it would not have been because of a market failure (a bubble) but rather because of an organizational failure - the failure of lenders to use the market to hedge or the failure of the long side of the market to manage risk.

In this sense, Shiller and Kay are both half-right. Shiller's right that more markets can mitigate market failure, if not organizational failure. But Kay's right to say that markets can't always protect us from human stupidity. 

Comments

[Matthew]

Doesn't leverage and the time-frame make it unworkable for normal people?

Say I'm buying a £200k house with a £20k deposit and £180k mortgage. But I can't afford it for a few years so I take out £200k (assuming derivatives not projecting gains or falls) of housing futures to fully hedge myself.

Also, the underlying is very illiquid and non-fungible, which I think could make it a very bad hedge.

[Woj]

Interesting thought experiment. It would seem that one only needs to look at the other recent bubbles in tech stocks and '08 commodities to see that options and futures markets don't prevent bubbles. The only way to truly eliminate bubbles would be to eliminate markets.

[George Hallam]

"I suspect there's no way of telling what would really have happened in this parallel universe. This, though, doesn't mean this thought experiment is useless."

99 times out of 100, I warmly applaud articles on this site. Today's the 100th time.

[Kraut]

"One is that the bubble in derviatives might have been accompanied by counterparty risk. Those who wrongly went long might not have been able to pay the shorters."

That's why futures exchanges use margin deposits and clearing houses. Your counterparty exposure is to the clearing house, not the person you traded with.

Coincidentally, the margin mechanics might make such an exchange unusable for non-professional traders, though.

[Account Deleted]

This parallel universe would have two common features with our own: persistent demand for property in London and the South East, and inadequate levels of house-building to replenish and expand supply.

Residential property is about 60% of the total asset base of the UK (4tn out of 6.7tn). London & SE accounts for about half of all residential property by value, so roughly a third of national wealth.

I think the key point in your analysis is "mortgage lenders might not have used derivatives to hedge their exposure". National mortgage lenders can treat London & SE as a hedge for the rest of the UK. That perhaps explains their "over-optimism".

Future downsizers would not be a big enough cohort on their own to create an active short market. With excessive demand for long positions, it's hard to see a market being created at all. Periodic price drops have only occured once a decade and the long-run trend is way ahead of most other asset classes.

Property prices are now rising again in London despite a recession. Given the extent to which this is driven by foreign money, it is hard to see the market falling any time soon, and thus hard to see enough of a balance of risk to make a derivative market.

[PaulB]

"One possibility is that the weight of shorting from hedgers would have been great, and this would have held derivatives prices down. Arbitrage would then have caused physical house prices to be lower."

How would that work? House price futures are below cash prices, so I arbitrage that by shorting a representative basket of houses and buying the future. How do I short houses?

It seems to me that a more plausible mechanism is that mortgage lenders would be willing to lend a smaller proportion of the asking price in these circumstances.

[chaussures converse]

Pentru a examina acest nivel de bani de taxe respectiv garanta spate, vizitaţi
TARIFE site-uri, ca urmare a căuta el pe tot parcursul Google căutare.Acesta este motivul pentru schimburi de contracte futures utiliza depozitele în marjă şi case de compensare. Expunerea contrapartidă este de a casei de compensare nu, persoana pe care cu tranzacţionate.

[converse pas cher]

Ne-am putea dori apoi să modifice mediul înconjurător pentru a compensa diferenţele de capacitatea de alte dar păstrând cu grijă acei factori care promovează sau împiedica punerea în aplicare. Ca şi capacitatea de atentie concentrata, ceva cu corelează uriaşe biologice.

[Paolo SIciliani]

Let's imagine there had been a big, active, liquid market in house price futures and options....wait a second, the underlying market in segmented at almost the street level, so how do you think the derivatives market could be big active and liquid? Besides, since long position are taken by prospective buyers to be able to pay down a larger deposit in the face of rising high prices, wouldn't sellers (opportunistically) price that into asking prices, thus creating a feedback loop between the underlying and the derivative market that increases the risk of (irrational) bubbles?

[Tom]

We do know that short buyer Dr. Michael Burry made about a billion USD (The Big Short, by Michael Lewis).
And, after 2006, tho not before while the bubble was inflating, there was a LOT more interest in his short positions.

"This time it's different" -- ha, there WILL be another financial/ asset bubble in the next X years (with large enough X: 40? 20? 10?). At such time, having an active futures market will be far preferable than having over-powered regulators who are getting it wrong.