Tuesday, September 12, 2006

The Line Between Gambling and Investing

This past weekend, the Sunday NY Times included a new magazine called Key, focusing on real estate. In between all the ads for luxury condos, there were some interesting articles, including one about the housing futures market: The Pork Bellies Approach to Housing. I'd heard that housing futures were being traded on the Chicago Mercantile Exchange -- Matrix sometimes posts updates on how the market is doing, which I have to confess I don't entirely understand.
The NYT article helps explain it a bit: basically investors bet on whether they think housing prices will go up or down:

If I think housing prices in Washington are likely to rise by 10 percent next year, I can place a bet that earns me a profit if I’m right. If I think housing prices are likely to fall, I can place that bet, too....

In fact, once you start chewing over the benefits of housing futures, the world starts to look a little different. For example, you don’t have to live in Washington to invest in the local housing market. You can be in some chronically unsexy market — a place like Des Moines or Indianapolis — that would have normally make you a bystander to the recent housing boom. Or conversely, suppose you’re one of those Manhattanites who have seen the value of your brownstone triple in the last decade. You’ll be retiring soon, and the last thing you need is to have the bottom fall out before you move to Florida. Now, like a risk-averse hog farmer, you can lock in your profits by betting on prices to fall. Or maybe you’re a builder in California worried that a new development won’t fill up. Suddenly you can hedge your risk and not worry about losing your shirt if the market turns.

Housing and pork bellies aren't the only futures markets-- you can also invest, or bet on, what you think the weather will be in the future. I find this bizarre. All investing has some element of gambling to it-- I suppose even FDIC insured bank accounts earn fluctuating rates of interest that add some element of risk to them. But at least when you buy a stock, you are buying a share in something kind of tangible, and you can feel like you are putting money into a business that will then do well and you'll get back some portion of the proceeds. But weather futures? Why don't they just start offering horse race futures and dogtrack futures? Blackjack futures and roulette futures wouldn't be too far off... and maybe I could someday make a fortune going short on lottery futures...
I'm taking this to an absurd extreme, of course, and into a realm where complete randomness takes over from some degree of predictability, but where do you draw the line? What makes one kind of bet gambling, and therefore often illegal, and another kind of bet investing, and therefore considered legal and respectable in most circles?


Charles said...

Madame X,

It's an interesting post, and this may be too technical. But regular home buyers are basically playing options without opening a brokerage account. When you use an interest only loan, each month you're only buying rights to sell the house in the future, you're never actually buying the house. This is something I penned, and shopped around. Thought it was appropriate to today's post.


Option Nation

It is ironic that one of the most popular loans in the country these days is called the Option ARM, so named because it gives individuals the option to choose a payment scheme. But this is more than apt, because in effect it has turned much of middle america into Options traders of the Black Scholes variety instead. But instead of just losing the price of the option, buyers are exposing themselves to huge debt obligations that they cannot escape.

Individuals are no longer obtaining loans, but instead have subscribed to an ongoing series of call options with these interest only loans. For those not familiar with options, an option is basically a right that is purchased to obtain something at a given price. When an option is exercised, the purchaser of the option usually "buys" the agreed item and then immediately sells it at the market price pocketing the difference. This is most frequently done with stocks, but is a very complex financial instrument that SEC requirements require brokers to take prudent steps that the options trader is sophisticated enough to make these transactions.

With the new interest only loans, many home buyers are participating in the same behavior but using their home instead of stocks. They are also taking out a loan, but it is a loan only in name only. With interest only loans, buyers are not service the loan principal, but merely paying rent to the bank on their house. They in effect have entered a contract to buy the house for the amount of the mortage (in some cases exceeding the value of the house after home equity line of credits are included). Every month they renew the contract for another 30 days, permitting them option of selling the house and pocketing the difference. This works great for rising markets, but when prices go down it in effect puts home owners on the hook for covering what is in technical terms a naked call for the price of the mortgage. In negative amortization loans where the loan amount can grow the impact can be even worse.

There has been an increase in the securitization of everything that occurs in our economy, and in many ways this mitigates risk in the right hands. But the rise and popularity of interest only loans, has made a traditional conservative investment for middle America, into one that is equal to one of the most dangerous trading vehicles out there. Something that most people wouldn't qualify for with a stock, is being made easily available to the most important asset most people will ever own, their home. When someone gets burned, there's usually fire and it won't only be the house that's lost in flames.

Anonymous said...

What makes one gambling and the other investing? What makes killing an animal sometimes a crime, sometimes hunting? And so on?

It always depends on the interests of the lobbies that sponsor those who write and vote the laws. Rarely, if there is a public outcry, things change. But only for a while. Then we're back to the interests of the very-very-very rich. It's been like this since the dawn of man.

enoughwealth@yahoo.com said...

Yes, trading futures is just gambling - it's basically a zero sum game. However, futures are a good thing IF used as intended - to hedge the risk of an EXISTING asset. Eg. if you are a farmer with a field full of ripening corn that would be worthless if the weather goes bad, buying an option that offsets that risk makes perfect sense. But it is insurance, not an investment.

The other point I'd make is that interest only loans on housing are not really the same as just an option to sell, as you have actually borrowed the money and bought the underlying asset. A true option would only give you the right to buy/sell an asset that you don't actually own. Also, most home buyers using an interest only loan would intend to eventually take out a standard loan and eventually pay it off. They only take out the Interest Only loan as they can't afford the repayments of a P+I loan.

Interest only loans will increase the borrowers gearing, but in the first few years you haven't paid off much principal with a P+I 30 year loan anyhow, so there's not much difference. Actually, if you borrow the SAME amount for a house using an interest only loan instead of a P+I loan you're actually REDUCING your risk - you're exposed to the same capital loss if house prices decrease, but, because you're payments are lower, you're less likely to default on payments and loose your home.

ps. I have both types of loans - my home is a P+I loan (but here in Australia the interest rate is variable, rather than fixed. I also have an Interest only loan for a investment property. It used to be P+I but I have paid off enough that my equity is around 50%, and I want to keep the interest payments approx. equal to the rental income so that I don't have to pay more tax (by getting more net income from the property).

For a view of what a housing bubble bursting looks like, see my recent post on http://www.enoughwealth.blogspot.com -it has a graph of the my property values during a boom & bust cycle.

Charles said...


You do have a valid point, I didn't mean as a literal option, but an analogy that "owners" with Interest Only loans are not really "buying" a house, they are really just acquiring rights for appreciation (or risks of depreciation). One could argue equity, but with individuals putting 0% down, in effect they are buying an option for the entire price of the house and then refreshing it monthly. The situation is much worse than an option. In theory, it could be as good as rent, but in practice it's not.

mOOm said...

First I see no reason why in the US some gambling - lotteries is legal and other gambling is only allowed in some locations - e.g. Indian Reservations, Las Vegas etc. The whole thing is absurd.

Derivatives markets have various purposes - as mentioned one is hedging away unwanted risk and on the other side of the deal the seller is selling insurance in the case of the options market. If you sell options it is just like being an insurance company for example, though the risk you are insuring is somewhat exotic perhaps.

Futures contracts hedge risk differently to insurance. Buyers and sellers might be both hedging or both speculating or a mix. With a weather contract a farmer could be on one side and a crop buyer on the other or a heating oil firm and big consumer. Both could be hedging their risk.

How speculative is it to buy an S&P 500 futures contract vs. buy shares in an index fund or an ETF? - there is no real difference. The key thing is not to take on too much risk and the futures market allows people to trade with very low margins compared to the stock market and can tempt them to use too much leverage. An advantage of the futures market in the US vs. the stock market is that futures trades are taxed much lower than short stock trades under the 60/40 rule.

Anonymous said...

"S&P 500 futures contract vs. buy shares in an index fund or an ETF?"

Leverage , leverage. You are much more likely to swing profit/loss more than 100% of your original investment. I believe the difference is very significant