There are few, if any, markets that would benefit more from financial innovation than the U.S. housing market. The global repercussions of the home price boom and bust over the past decade, the subprime mortgage debacle, and the controversy surrounding Abacus underscore just how obsolete, inefficient, and incomplete the residential real estate market is, and how financial innovation and well-functioning derivatives markets are needed to manage home price risk.

Abacus, along with other subprime mortgage derivatives transactions, has been decried by some as “side bets” and having “no redeeming social purpose”. While there is little disagreement that some such devices and markets within which they trade have significant flaws, and that institutional “end-users” would benefit from greater transparency and smart regulatory oversight, critics who favor draconian measures might pause to consider whether, and by how much, financial markets might be in worse shape today if, in 2006 and 2007, clear-headed investors and risk managers were unable to express a pessimistic view on, or hedge exposure to, future home prices and/or subprime mortgage credit in the OTC marketplace. While use of subprime mortgage credit derivatives to express a view on single-family real estate may seem like an indirect and complex way to short U.S. housing or hedge home price risk, these instruments were, arguably, the only means for institutions to establish meaningful positions at the time. They were considered by most users a proxy for the future fortunes of residential real estate, and could be bought and sold in sizes that those who were hungry for long or short housing exposure were commanding. Yes, ideally, there would have been more open, timely, direct, and efficient ways to price and trade home price risk. But the OTC subprime mortgage derivatives market did enable massive short positions on housing and credit, and thus served an important purpose: facilitating the delivery of signals that home prices were on an unsustainable trajectory, and that hyperactive subprime lending practices were idiotic. The synthetic variety of subprime CDO swaps might also have had the (unintended, but beneficial) effect of reducing the number of real, toxic subprime mortgage loans that might have otherwise been originated for borrowers destined to default on them.

As of year-end 2009, the aggregate value of the capital stock of U.S. single-family housing owned by households was $16.6 trillion, while the aggregate market capitalization of all U.S.-listed stocks was $15.1 trillion. Yet, to this day, there is very limited market infrastructure, and no liquid means to manage and trade this massive and important risk in a direct fashion. This hasn’t been from a lack of trying, and efforts to create market infrastructure to effectively price and manage home price risk are ongoing. A small company that I used to work for, Case-Shiller Weiss, was briefly engaged by the CBOT in 1992 to explore development of a home price futures market. In 2004, MacroMarkets made its first SEC filing for housing MacroShares (public, stock exchange-listed collateralized trusts with returns linked to Case-Shiller Indices). In 2006, CME Group launched markets for home price futures and options. In 2007, OTC markets for swaps and forwards were initiated and standard ISDA documentation developed. In 2009, Housing MacroShares were launched by MacroMarkets following their approval by the SEC and listed on NYSE/Arca.

The efforts to establish infrastructure to enable more efficient pricing of, investment and trading in this $16.6 trillion asset class via exchange and OTC markets are ongoing at MacroMarkets and elsewhere (see guest column by John Dolan, “Using CME Home Price Futures to Express Views on Forward Home Prices”). It is reasonable to conclude that if there had been more direct, publicly-accessible, and transparent means to short U.S. housing at the start of the decade and throughout the go-go years that followed, the bubble and subsequent crisis could have been averted, or at the very least, its dimensions contained. Financial innovations conducive to improved home price risk management are necessary and long overdue.