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Banking

Property Derivatives Pick Up

As the price of home and commercial real estate plummeted, hedge funds and pension funds have been tuning into how to curb losses and speculate on values of real estate using property derivatives. Activity in the instruments picked up during the last quarter of this year, principally as a result of their participation. Liquidity on the RPX, an index representing average home prices paid per square foot in metropolitan areas, saw 40% of its annual volume from September through November.

Some pension funds and commercial property owners began using derivatives late in the game once their losses began to escalate. "We got a lot of phone calls for fire insurance while the house was on fire," said Kiva Patten, director and head of property derivatives at Merrill Lynch in New York.

The same investors are trading forward-style contracts on the National Council of Real Estate Investment Fiduciaries index, or NCREIF, allowing them to express a bearish view on the housing market. Pricing for a Dec. '09 swap on the NCREIF is already in negative territory relative to last year at -8%, indicating the market's view that property values will drop 25% in the next 15 months.

Investors have taken such a negative stance on housing that it has prompted some hedge funds to take the opposite directional view, "because it's so overdone," Patten said. Hedge fund clients are now looking to embed the index into their forecasts for property values and into their evaluation models on mortgage-backed securities, which Patten expects will fuel further growth in the sector into 2009.

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