The property swaps market
WEST BROMWICH BUILDING Society did very well out of the UK house price boom. But not just from supplying mortgages. The company also had a nice little earner in supplying retail investors with synthetic exposure to the residential property market through capital-guaranteed structured notes. The emergence of a derivatives market on property over the past few years, led by the dealing desks of investment banks, meant that West Bromwich could buy exposure to house prices via swap agreements with banks before selling it on in note format to end investors. Recent house price upheavals, however, have had a nasty effect on the market.
"We don’t plan to look at either commercial or residential indices for some time," says Andy Heseltine, West Bromwich’s savings and investment product manager. The building society was still marketing property price-linked notes at the start of the year. Specifically, it was selling a five-year, capital-guaranteed product that offered investors exposure equally to the performance of the FTSE100 and the Halifax House Price Index (HPI). Heseltine says sales have been disappointing. "The general appeal went towards the end of the offer period. Over the last three or four months the media coverage, and the actual performance figures, have not been that exciting," he says.
Doom and gloom
The gloom that surrounds the UK housing market probably has a lot to do with the fall in demand. Retail investors in particular like nothing better than going long during a bull run. But that’s not the whole story. Dealers report a big fall in liquidity in the UK real estate derivatives market over the past six months. As structured note manufacturers such as West Bromwich Building Society rely on this market to source the risk that goes into their products, a big reduction in liquidity – especially when liquidity was still at the initial stages of just being built up – could be a serious impediment for those looking to make new products.
"A key feature over the last nine months has been the sheer volatility of the underlying property market, and thus the derivatives market, and this has caught some derivatives players by surprise. Some have retreated from the market, which has meant that over the last six to nine months liquidity has significantly reduced," reports Charlie Harris, head of property derivatives at Royal Bank of Scotland in London. "The peak of liquidity was probably this time a year ago, and now I think we’re back where we were at the end of 2005."
The only reason a property-linked structured note market exists at all is thanks to the development of a reasonably liquid property swaps market over the past few years (see The property swaps market ). The underlying for the swaps market tends to be established property price indices. In the UK that means the Halifax HPI for those looking to trade the residential market, which is derived from the mortgage data of the country’s biggest mortgage lender, and the Investment Property Databank (IPD) UK Annual Index Total Return covering the commercial market, which is based on annual property valuations of property investors, including pensions funds, charities, insurance companies and public property companies. The UK has by a long stretch the most developed property derivatives market in the world, and the most developed related structured note market. Trades have also taken place on commercial property in France and Germany, and some activity is also reported from the US. There are also signs that a market could eventually get started in Asia but the UK leads the way.
Some of the most common types of structured note bought by retail investors simply offer a capital guarantee plus leveraged exposure to a house price index, typically the Halifax HPI. For example, a dealer might issue a five-year, principal-protected note that pays one-and-a-half times any growth in the Halifax HPI over the five-year period. Hybrid notes that come with an element of house price exposure, such as the ones that West Bromwich was selling, have also been popular. RBS, for example, last year marketed a capital-protected note that offered one-third fixed-rate return, one-third exposure to the Footsie and one-third exposure to the Halifax HPI.
One of the biggest selling retail products was the €1.2 billion sale of property index certificates (Pics) by Barclays Capital, which hit the market in 2004 and were put together with Protego Real Estate Investors, a London property investment boutique. Pics were linked to the performance of the IPD Annual Total Return Index. The three-year, non-capital guaranteed notes paid an annualized income return, payable quarterly, and a capital return paid at redemption.
So how damaging has the drop in swaps market liquidity been? Harris says spreads in the UK have widened and the sizes being traded are proportionately smaller, but you can still trade. "It’s just more difficult to source risk. You can get prices no problem on £5 million notional, and you could probably do £10 million. But if you wanted to do £25 million and upwards, it’s more difficult," he says.
The big question is whether the liquidity will return. The property derivatives market has a number of idiosyncrasies that make it a tricky place for investment banks to operate. Pricing a property derivative is difficult because there is no natural reference point with which to begin to take a view on what the spread over Libor should be. Interest rate swaps are quoted as a spread over government bond yields. When inflation swaps started to get traded, market makers could look to the break-even inflation rate on government index-linked bonds to gain a sense of what the price should be. But there is no equivalent reference point for property derivatives, which means pricing generally boils down to taking a view. This is not helped by the fact that the underlying physical property market is opaque – it is difficult to work out what the actual price paid for a property is after fees and so on.