Mortgage Default Risk and Real Estate Prices: The Use of Index-Based Futures and Options in Real Estate

Evidence is shown, using US foreclosure data by state 1975–93, that periods of high default rates on home mortgages strongly tend to follow real estate price declines or interruptions in real estate price increase. The relation between price decline and foreclosure rates is modelled using a distributed lag. Using this model, holders of residential mortgage portfolios could hedge some of the risk of default by taking positions in futures or options markets for residential real estate prices, were such markets to be established. In a previous paper (Case, Shiller and Weiss, 1993) we argued that there is a need for a liquid, national hedging market in real estate prices. We proposed futures and options markets that are cash settled based on indices of city or region residential real estate prices. Individual homeowners are the largest bearers of residential real estate risk, and they have the most to gain from hedging in such markets. Homeowners are for the most part highly leveraged and undiversified. However, while hedging would provide great benefits to homeowners, most are unsophisticated financial managers, certainly unaccustomed to using derivative markets. The likely reluctance of homeowners to make use of hedging markets represents an obstacle to their establishment. It is more likely that homeowners would use riskmanagement services that were offered to them by retailers who present the services in attractive packages and who market them appropriately. If liquid markets for real estate risk existed, then one might expect to see eventual development of such retailers who would then