The Wall Street Journal Gets It Wrong

I expect housing prices to fall.  In fact, they already have fallen nationwide from their peak.  However, the Wall Street Journal gets it wrong when discussing the new housing futures market. The topic of Monday's Ahead of the Tape column was how the fledgling housing futures market was predicting a fall in housing prices.

In May, futures contracts based on home prices began trading on the Chicago Mercantile Exchange. You buy a contract for, say, $50,000. If prices go up or down by 10%, it's worth $5,000 more or less. Investors buy or sell such contracts based on where they think prices are going.

The contracts suggest price drops by next summer (emphasis added) for average single-family homes will range from 5.9% in the Chicago area to 8.5% in San Diego and Miami areas. A contract based on 10 regions suggests a 7.2% decline.

This is incorrect.  The curve of the futures market does not predict future prices.  Instead, backwardation in the futures market merely suggests that an investor is willing to sell his or her product at a lower price some time in the future. 

There are three states of the futures market - flat, backwardation and contango.  A flat curve is when the price of a commodity for delivery at future dates are the same.  For practical purposes, this is rare.  Backwardation is when prices for future delivery is lower than the current spot price.  Contango is when prices for future delivery are higher than the current spot price.  In our current example, the housing futures market is in backwardation. 

Many commodities exhibit backwardation.  There are a few reasons why a futures market might sell at lower prices than spot prices.  The motivations of sellers may be the most important reason, or at least in this case it may be.  If a seller wants to hedge against future price declines, then to take on the risk of future price declines, the speculator who wishes to buy such contracts should demand a risk premium.  The longer the time period and thus the greater the risk of a price decline, the greater the risk premium and the lower the price of the future.  Thus, in essence, the premium required to entice the speculator into the market is like an insurance premium for the seller to transfer the risk from the seller to the buyer. 

Another reason is the cost of storage.  The higher the cost of storage, the greater the cost of the premium to the seller.  So, for example, if someone was selling commodity X for $1000 per unit of measurement, if the cost to store the commodity was $20 per month, then the seller would be willing to sell his product forward for $940 in three months.  In our housing market example, the cost of the house would be the cost of upkeeping the house - taxes, insurance, maintenance, perhaps a mortgage, etc.  So the natural state of the housing futures market may be backwardation.

Oddly, the author gets it right at the end of the article.

Too many such sellers would drive down prices. Futures markets driven by one-sided hedging lose predictive value, says University of Iowa finance professor Thomas Rietz, one of the brains behind the political futures on Iowa Electronic Markets.