Vlad Krutik, ceo of International Real Estate Securities Exchange (IRESE), answers SCI's questions

Vlad Krutik

Q: How and when did your firm become involved in the structured credit market?
A: The genesis of IRESE was conceived about 2.5 years ago. At that time, a couple of academics (including Harry Markowitz) and I talked about investment opportunities in the real estate market. Specifically, we discussed the leverage that real estate provides and how easy it is to securitise mortgages and sell them on so that at some point someone else holds the paper, yet perhaps doesn't understand or realise its value.

The logic was that if you pool a number of mortgages together, it is easy to trade them. But the current market situation has disproved this theory and now it is even harder to determine values.

The complexity of pricing mortgages has been overblown: we want to remove that complexity in order to address the need for liquidity. We looked at the theory behind trading options in the stock market in order to hedge various risks.

Similar to MBS, options are financial products that have an underlying asset; however, the value of an option is determined by the passage of time based on an index. So we decided to create financial instruments - real estate notes and real estate options - that essentially unbundle the securitisation structure and establish an exchange to facilitate mortgage trading.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
A: We're targeting property owners and developers, mortgage originators and brokers, and qualified investors. Both commercial and residential property is traded on IRESE.

Q: What is your strategy?
A: A real estate note structure involves breaking a loan into many different interest-bearing notes that represent a fraction of the whole loan. Each note has a face value of US$100, representing one unit of investment, and a variable interest rate that is set by investors at origination. The rate is determined at the time of initial real estate note offer and set by investors, who bid on the offer based on their initial loan risk assessment.

A loan can be profiled by the borrower's credit score, loan-to-value and debt-to-income ratios. Based on investor-defined weighted scores, a specific risk profile receives a score from 1-1000.

IRESE provides all the due diligence the mortgage originator has with the offer, including property owner FICO score range, debt-to-income ratio, loan-to-value ratio, a certified property appraisal and any other additional information provided by a lender. The interest rate on the note is determined through a Dutch auction.

The mortgage owner will be obligated to make monthly payment interest plus principal for a duration of the note or until the property is sold or refinanced. At that point, investors receive the remaining balance of the note principal back. The mortgage owner will continue to be responsible for the customer service, loan servicing and any other loan related activities.

At any time an investor might want to sell the note holdings at the market price. The price is determined by a discount or a premium of the original value of US$100, depending on changes in the risk profile associated with the loan and level of risk free interest rate.

A real estate option, on the other hand, is a contract for a potential payoff at a future date on a predetermined expected value of a specific property. Property owners can sell an option in exchange for debt-free cash or buy an option to limit their exposure to declines in property prices. Investors can selectively buy or sell individual fractions of options based on the future value of specific properties.

A real estate option is not an equity participation or a fractional share of ownership. It is a derivative that is engineered based on the change in value of the underlying asset, a property.

There are two types of options: a real estate call option and real estate put option. The call option property owner can sell an option in exchange for debt-free cash. An investor in a call option benefits from property price appreciation and price volatility.

With a put option, an investor can sell an option and thus underwrite price decline insurance. A property owner, who buys the option, is protected against price decline of the property.

Pricing an option involves a price of an asset, time period and strike price. Option pricing methods require that the underlying asset has a readily available observed market price of any given property at any given time. Since properties are not sold often, IRESE offers a way to derive an observed price of a property based on a weighted combination of publicly available price indices.

These indices are the Case-Shiller Index, the Office of Federal Housing Enterprise Oversight (OFHEO) Home Price Index (HPI) and the Zindex home value index from Zillow, which is publicly available for most properties. By combining the weighted average of publicly available index data, an individual property owner and an investor can find out the value of any property at any given time by applying index change data to the last recorded sale price and sale date for the property. There can be no argument about the value because it is a public index and so can't be manipulated.

IRESE proposes to address moral hazard by allowing the property owner to share only up to 50% of the contract payout. In this case, a limited payout discourages any adverse activities.

Q: How do you differentiate yourself from your competitors?
A: The Chicago Board Options Exchange recently launched futures and options based on the Case-Shiller index (CSI) for largest six metropolitan areas. CSI is a geographical index that is updated every month and captures trends in price changes for a select metropolitan area.

Investors can use the CSI to trade options on a derivative based on observed changes in the value of the index. CSI is an aggregate of the changes in market prices and is focused on the past performance of a regional price change. In contrast, a real estate valuation is location specific.

Our objective is to allow investors to create their own risk profiles and then build the appropriate dynamic pools, as well as to provide them with automated tools to manage the portfolio. We'll alert investors if the risk profile of the mortgages they hold changes, so that they can trade out of the positions if they want. There will always be buyers and sellers for certain risk profiles and/or market makers ready to step in if necessary.

IRESE is innovative because end-users are exposed to the risk/reward of real estate, but don't have to physically buy or sell it.

Q: Which challenges/opportunities does the current financial environment offer your business and how do you intend to manage them?
A: So far we've had significant interest from property developers and mortgage originators, who are interested in price decline insurance so that they won't have to foreclose if they can't refinance, and originators that want to be compensated for any potential price declines. Additionally, we're targeting mortgage brokers that want to add the line item in origination or those who offer reverse mortgages. It's a viable alternative to a reverse mortgage because there are no age restrictions and the borrower doesn't have to give up their home, yet it enables them to tap the wealth built up in their property.

We have CFTC approval to commence trading and we're currently in the process of beta testing with a number of customers. We're also aligning ourselves with a few institutional investors that are looking for alternative investments in compensation for the lack of yield in equities.

Q: What major developments do you need/expect from the market in the future?
A: We've had conversations with the government, but the issue is that the housing crisis in the US is at the trillions-of-dollars mark and the government is looking to simply write a cheque. If you can afford to write a blank cheque, why would you sit down to analyse the fundamental problems in the housing market and try to come up with an alternative solution?

However, throwing new money after old isn't going to clear the system. IRESE is one alternative to help solve the problem, and we continue to explore with the US government how we fit into the rescue plans.

There are option markets for equities and there is no reason why there can't be for real estate, given that the value of the asset changes over time. I anticipate that in five years' time, say, the new issue MBS market will comprise of only government-guaranteed bonds. Alongside this will develop a new market for simpler structured real estate instruments similar to ours that focus on pricing according to risk and dynamic pooling - the alternative just isn't efficient anymore.

Of course, it will be more complicated to develop such instruments for auto loans or credit cards because they don't have detailed data that is publicly available. Nevertheless, there are opportunities to create new instruments that go back to the basics of the underlying assets.

About International Real Estate Securities Exchange (IRESE)
IRESE is the first internet-based, government regulated market where mortgage bankers can securitise their loans, property owners insure against price decline, and investors benefit from real estate price movements and fixed rate of return from diversified fixed income investments. IRESE's website enables members to trade small, inexpensive, easy-to-understand real estate notes and real estate options contracts in international real estate markets.

IRESE is a secure, fully-transparent marketplace, subject to regulatory oversight by the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC).

CS