Housing bubble, and possible hedge

Robert Shiller, the Yale economist who coined the phrase "irrational exuberance" to describe the tech bubble, has been advocating new financial instruments that let ordinary people manage the increasing levels of risk in their financial lives. This NYT article describes new derivative instruments designed by Shiller's company that are essentially index funds linked to home prices in certain major markets. They will trade on the Chicago Mercantile Exchange and allow investors to, e.g., hedge against a decline in real estate values in their city.

Interestingly, there will be a pair of derivatives linked to each underlying index, whose prices behave oppositely. This allows bets against the index without requiring a short position that might lead to margin calls or unbounded losses. One mismatch between the Shiller indices and the actual housing markets is the favorable tax treatment of leverage for someone who buys a house (as opposed to the index).

"Volatile markets are increasingly becoming a part of our lives," Mr. Shiller added. "The home market itself is becoming more volatile. We're in the biggest real estate bubble in history, I believe.

Nationwide, home prices rose 7 percent a year, on average, from 1999 to 2003, roughly double the rate for rental prices. Over the previous 15 years, the two rose more or less in tandem, with one outpacing the other for a while before the pattern reversed. I discussed bubble dynamics in a previous post.