Real estate investors need to get into the mind of the banker to understand why they made some important mistakes in attempting to develop the property derivatives markets, says Jose Luis Pellicer
In the previous issue of IPE Real Estate I argued that real estate fund managers ought to spend both time and resources in understanding the benefits of using property derivatives as a risk management tool - ie explore their use/effect in both hedging and portfolio rebalancing.
It turns out they have the in-house expertise to do so: real estate researchers and company treasurers. Eventually, I argued, the real estate research function ought to be subdivided in two: proper research and real estate risk management.
Yet, all this investment may turn spurious without bankers' full engagement in the market. That is to say, in the same way that property professionals need to become deeply acquainted with the effect of property derivatives on their portfolios, bankers also need to understand their clients' needs and provide liquidity in the areas that suit their clients best. Paradoxical, isn't it?
Well, bankers also need to change their mindsets and re-direct their risk-taking towards areas from which the property industry can truly benefit. In short, bankers need to facilitate UK sector trading.
This may look fairly obvious to a property professional at first sight, but it is not necessarily so. Bankers typically think in two dimensions: product sophistication and geographical expansion. In terms of sophistication, bankers are used to dealing with products whose underlying assets are liquid, easy to divide and highly homogeneous.
Think, for example, of a share, a bond, an interest rate swap or a foreign exchange contract. With products of these characteristics, traders can easily build extremely complex positions in their books, including all sorts of futures, options or other derivatives. As the underlying assets are tradable, liquid and small, any position can be instantly closed should they need to. A trader's job is, therefore, to be constantly monitoring the sensitivity of the value of his positions to movements in the underlying asset prices.
When it came to property derivatives, bankers thought of them just as a ‘derivatives market on a major asset class that needs to be developed', and therefore, immediately tried to write (or buy) options.
Incidentally, with this in mind, the reader can now understand that the crisis in asset backed securities and commercial mortgage backed securities (CMBS) that partly triggered the credit crunch was nothing but a special case of this ‘product sophistication' dimension.
The underlying assets - in this case mortgages - could not be easily traded and had to stay in the banks' books as they kept losing value. CMBS was, in a way, an attempt to homogenise a heterogeneous asset through rating tranches. The idea was good, but it grew too big, too fast and became over-sophisticated (things like CDO-squared transactions, for example).
The second dimension (geography) is easier to understand. Those homogeneous/liquid/divisible asset classes I referred to above are available in most European countries: all European governments or major European companies issue bonds and shares, all have major national stock markets and stock indices (which can be reduplicated by buying the underlying stock) and all countries have a currency.
It is in the context of these two dimensions that bankers tried to develop property derivatives - in exactly the same way as they developed derivatives markets in other asset classes. They made the product too sophisticated and expanded it geographically. Some bankers even wrote option contracts on International Property Databank (IPD) indices and sold principal protected notes based on the IPD total return index or the IPD capital growth index.
They also tried to develop the trading on the German, Italian and Spanish IPD indices. I once even learned of an option on the German IPD index (no comment). But most importantly, having taken a lot of risk on their books, most traders neglected UK sector trading - clearly one of the most obvious benefits of property derivatives from a property fund manager point of view. Indeed, IPD is best known in the UK (far more than in France, Germany, Italy or Spain).
The IPD benchmarking service is used by nearly every major institutional property fund manager in the UK. But bankers did not recognise this. Instead, very few sub-sector based trades were actually transacted. The few sector (as opposed to sub-sector) trades that were quoted (not just transacted) put property professionals off because of their draconian bid offer spreads.
This was a fatal mistake that alienated many of the property professionals that worked hard to make property derivatives possible. What is the point of having a property derivatives market, many real estate fund managers would wonder, if I cannot rebalance my portfolio? The naivety of such a situation is enhanced by the fact that sector trading was actually better for bankers themselves. Indeed, let us assume that a banker has assumed a long position on French offices and a short position on UK all-property.
The correlation between both is low, so the banker is not effectively hedging one with the other, but instead is taking two different risks. Yet, if the position were long UK all-property and short UK shopping centres, the correlation is much higher and the trader would thus be both partially hedged (a much better position to be in) and would be offering a better service to the industry as a whole.
So, what were bankers thinking of? Is this not a gain-gain situation? Of course it is, but bankers have a hard time thinking at sector level. Again they would sell options on UK all-property and delta hedge, rather than sell retail and buy industrial.
And this takes me to the final extra variable that made all of the above possible: distrust. Indeed, banks lost quite a lot of money in their first proprietary trades, which made them come to the conclusion that ‘property people know better than us', hence their wariness to move into sectors. Bankers refused to provide liquidity in sectors just because they were afraid of being hoodwinked by real estate professionals.
Three years after the start of the property derivatives market we find ourselves in a standstill situation. But what I call traditional property fund managers are not the only ones to blame. The banker's view of the world, it turns out, appears not to be broad enough to overcome the key hurdles facing the full development of the property derivatives sector.
But the industry is resilient and has managed to go far enough to prompt Eurex to create a recently launched property futures exchange. Let us hope they do not fall for the same old mistake.