Thanks to Bryan Caplan for his excellent post this morning. In the Comments section, people discussed the difficulty of shorting housing even if you thought it was overpriced. I’ll tell two stories of two friends who saw what was happening. One didn’t act on his insight and one did.
First, the friend who didn’t act. He lives in about the only at-all upscale neighborhood in Detroit. In about 2005, people bought a house next to him and drastically overpaid, by his estimate, with a big mortgage from Washington Mutual. After buying, they let it sit. He sensed a scam between the buyer, the seller, and the appraiser. So he called WaMu and told them what he had observed. The person he talked to said, “Do you think we don’t know how to run our business?” She had no interest in learning more.
How could he have acted? By buying put options on WaMu stock. He didn’t.
In about the same year, another friend, who was a principal in a hedge fund, thought that California real estate was overpriced. If I remember correctly, he told me that 40% of all the value of residential real estate in the United States was in California alone. So he tried to get the other principals in the fund to buy puts on the stocks of banks that were heavily invested in California residential mortgages. He couldn’t persuade them. He did research to find which bank or banks were most at risk. He found one: Downey Savings and Loan. So he used his own assets to buy a large number of puts on their stock. He made out. He’s the only friend I know who had a substantial amount of wealth and didn’t lose net wealth when the crisis hit.
READER COMMENTS
Doug
May 24 2013 at 7:34pm
Buying put options is generally a terrible investment strategy that only works off if you’re very sure of a major event coming up as well as its timing.
Volatility is systematically overpriced so an investor that repeatedly buys options will see his portfolio go to zero given enough time. For example VXX is an ETF that does pretty much nothing but buy put options or derivatives that replicate put options. It’s lost 80% of its value in the past year alone.
Even if you have the belief that a company’s going to go down you should short the stock and re-size to maintain a constant dollar position on the way down. Put options decay value over time, so unless you’re sure that the company’s going to have a blowup before the options expire (e.g. you know there next earnings announcement is going to be bad) you shouldn’t throw away your money.
My sense is your friend, like many other who shorted the housing market in one way or another, got lucky with his timing. The market can stay irrational longer than one can stay solvent. As humans we tend to lionize investors who get major predictions correct.
In reality one can achieve much better risk-adjusted performance by getting a bunch of uncorrelated small predictions correct. If you make one major investment decision a year you have to be correct a much higher percentage of the time then someone who makes thousands of investment decisions a year but gets 51% of them right.
Mark Brophy
May 24 2013 at 7:41pm
These stories remind me of Peter Lynch in his book, One Up on Wall Street. Ordinary people often have better info than pro stock traders. Some act on it but most sit on the sideline and assume the pros know better.
John Thacker
May 24 2013 at 8:36pm
I moved somewhere in 2005 and chose to rent when I could have afforded to buy, since rents seemed very cheap compared to buying, both from where I was moving and historically. For most people, that would be like shorting housing.
Jed Trott
May 24 2013 at 9:31pm
Someone in the comments in the post below mentioned this and I think it bears repeating; a strategy of buying puts relies on your counter-party surviving. That means that your payoff only occurs in the margin between whoever you shorted going under and your counter-party surviving on one hand and the entire financial system melting down on the other.
mike davis
May 25 2013 at 10:28am
Doug and Jed are both clear and correct. The only thing I’d add is that we’re all talking about ways to short markets for housing credit, not housing (they’re close but not the same thing). This raises the question of why financial entrepreneurs haven’t created more complete markets for housing?
My answer (with all the reflection one would expect from blog comment written over Saturday am coffee): Housing markets lack the daily volatility that motivates people to create markets. Energy and currency derivatives were not popular until the ’70’s when a post Bretton Woods world with a noisy OPEC increased volatility.
Doug
May 25 2013 at 4:53pm
@mike davis
CME offers futures on the Case-Schiller Index, but they have virtually no volume or liquidity. Like you say no one is really interested in trading them.
Ken P
May 25 2013 at 6:38pm
I haven’t had much luck with puts, even when my assessment was dead on. Timing is critical. Buying far out results in a major premium, buying shorter term puts makes the strategy super sensitive to the velocity of the price swing.
The pending housing bubble implosion was pretty obvious to me in 2006. Lots of events occurred in 2007, including Greenspan warning of double digit housing drops. I went almost 100% money market in my 401k in 2008, then decided I must be wrong and began buying back in during a 10% pullback… just in time for the big crash.
How would one time the WaMu drop? Start buying puts a year after Greenspan announced upcoming double digit drops? I’m guessing David’s friend is pretty savvy.
Michael
May 28 2013 at 1:11pm
@Jed Trott:
That only applies if you are buying OTC options (which I do not believe was being suggested). Exchange-traded options have almost no counterparty risk because of centralized clearing houses. That is one of the reasons regulators have pushed for certain derivatives to be moved to exchanges.
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