San Francisco Bay Area Home Prices to Drop 5.8% by August 2007

So predicts the Housing Futures Market on the Chicago Mercantile Exchange.

I've written before on the housing futures markets and I'm a huge fan. Housing is a such a significant financial exposure that until now has been very difficult to hedge. (This post is about the real-money market on the Merc, rather than our for-fun San Jose market on InklingMarkets.com)

Here's a vast oversimplification - Futures markets work by simply paying off when a given event occurs by a certain time in the future. So if I have significant financial exposure to a rise in, for example, fuel costs for an airline, I buy a futures contract that pays off because I expect fuel prices rise next year. This payoff offsets my newly expensive fuel. I've now hedged my risk against fuel prices and can focus on providing my customers with $5 boxes of something known as a "Mini Meal". If prices are less than my contract's strike price at the expiry date, then my contract expires worthless and, well, that's the cost of insurance. I've traded a known, smallish cost for an unknown potentially large cost.

And because futures markets are essentially a collection of people betting big money on their best expectations, they have a predictive effect. The more people that expect an event, the higher the cost of the contract until its cost equals the risk. Efficient futures markets measure the collective wisdom as of right now. That's why they're so cool.

So back to the new real estate futures market. Current prices on the CME show an expected decline of 5.8% between November 2006 and August 2007.

To be clear, these contracts are based on the Case-Shiller Housing Market Index which is a function of median single-family home sales prices. So the contracts expect a decline in the index not necessarily a decline in the price of your home.

I got a chance to speak with Shiller this week at the Inman conference where he clarified a few things about his vision for the market and the application of the market into real world tools. More on those innovations and their implications in a later post.