The basis risk as conventionally known in the hedging using derivatives on other types of assets takes on a little bit different meaning when it comes to real estate properties. This is simply because people actually use by living in their properties but not their stocks and bonds. They can easily control the alpha of the properties they own but not that easily the alpha of the stocks and bonds that they have invested in.
First let’s consider the trade-off between hedge ratio and the trading liquidity. Homeowners obviously will get a 100% hedge ratio if we use an individual property appraisal basis but there will not be much trading liquidity in order to create a market for lenders to lay off the property value risks to the investors. A market will not be able to develop on each individual property risk. Even if it is on a pooled basis in a residential trust or a fund it still lacks the efficiency of a freely tradable market.
There will also be many moral hazard and home improvement credit issues that have plagued the conventional non-derivatives based shared equity or shared appreciation mortgage markets experimented briefly in the US but have been around in the UK for decades. It never took off in a big way what it actually deserves in the UK primarily due to these issues. So an index-based derivatives approach have its obvious advantages over these conventional shared equity finance products. SwapRent (SM) and its embedded new mortgage products of HELM and FVCM were originally created as alternatives or replacements for these older shared equity/appreciation finance products.
So the key question is how do we create an ideal set of property price indexes that could satisfy both the hedge ratio demand for the homeowners and the trading liquidity requirements for the investors to make this new methodology commercially viable under the free market mechanism.
Although SwapRent (SM) and its related consumer finance products are index neutral, i.e. they could be used with any set of property price indexes or even without an index (on actual appraisal basis) we have developed a theoretically perfect set of property price indexes for this application purpose. There is a whole section (SPIM) in the business product white paper devoted to the discussion of these issues with detailed descriptions which I will not repeat here. More detailed info could be made available upon request. Although the SPIM represents an ideal way by drilling down to the neighborhood levels (the smallest definable neighborhoods of the like-kind properties) it may take a long time to create these new indices from scratch again and get the market acceptance and confidence. Due to the crisis nature at the moment of the potential subprime borrowers application we have simply been recommending the use of the city level OFHEO MSA HPI since it is already well known to the mortgage industry professionals. It may not give the homeowners the 97% to 99% hedge ratio but a 90% to 95% or even a 85% to 90% correlation may be good enough and on the other hand, the investors will have no problems holding a city level property value risk since there will be liquidity to trade it away if the market conditions command so.
What a more fundamental new economic concept is that these basis risks derived from the use of an index actually helps the homeowners. For example, the moral hazard and the home improvement issues of the conventional renting will be alleviated through the economic renting concept of SwapRent (SM). Again having the legal ownership will give you the alpha of holding an asset, switching to economically renting let you hedge away the beta of owning a property. Therefore a public housing project with economic renting will be a much better neighborhood than the one with a conventional renting only because people will invest in home improvement freely since they still legal own it no matter what happens next with the real estate markets in general. They will only give up the neighborhood appreciation/depreciation represented by a neighborhood or city property price index. Whatever home improvement investment they have already made in the properties they will be able to get to recoup those home improvement investments when they actually sell the properties later on.
In the extreme worst case that the neighborhood or city level index has appreciated more than the homeowners’ own houses have they would have nobody else to blame but themselves because they have not been able to maintain their houses the way they were supposed to. This is simply universally true with whatever properties people may own. If they did not do the necessary upkeep and maintenance so that the properties deteriorated and dropped in value they would not be able to put the blame on anybody else. This will give people the incentives to fix up their houses and do good things to improve their own neighborhoods relatively to the city or the nation. This is exactly what the city urban planners need to accomplish to let citizens enjoy the community smart growth which will lead to prosperous societies.
Therefore the basis risk is really a fortune in disguise when it comes to the use of property index based house valuation in SwapRent (SM) related transactions.