Yesterday I wrote this:

If I had to play homeowner psychoanalyst I would guess that homeowners with a strong preference for homeownership saw cap rates were changing and believed house prices were heading towards a permanently higher plateau that would permanently price them out of homeownership. People who would want to buy houses in the future but were currently renting had this fear as well and rushed into the market. Risk aversion here thus did not lead to selling when prices rose as a simple model might predict.

I was drawing on the work of Todd Sinai and Nicholas Souleles who have shown that housing works as a hedge against rental volatility. My thinking was that because owners often have strong preferences for home-ownership and are not indifferent between renting and owning, that those who planned to buy a house in the future would see buying a house now as a hedge against house price risk, much in the same way as the Sinai Souleles model. Well yesterday after I wrote that I came across a brand new paper that makes a very similar argument:

Our contribution is to focus on the importance of ownership as a hedge against future house price risk as individuals move up the ladder. We use a stylized model to show that increasing house price risk acts as an incentive to become a home owner earlier in the life-cycle and, once an owner, to move more rapidly up the housing ladder.

Increases in volatility are shown to increase ownership and to increase the quantity of housing wealth conditional on ownership in earlier periods of the life-cycle. We then establish that these relationships hold empirically using panel data on families in different geographic markets in Britain and in the US.

The authors use data from the UK and US to provide empirical support for their model. This is an under-explored causal mechanism for the bubble: house price risk went up, people bought homes to insure against that risk, which drove prices up, which increased perceived house price risk, etc. The cascading nature of this is clear, and it’s not hard to see how this could create a bubble.

So housing risk makes people want housing even more. I’m not sure if this will comfort or aggravate people like Felix Salmon and Ryan Avent who have been arguing that households are too risky in their housing consumption/investment decisions, but it should help explain why what looks to them like overly risky behavior is in fact caused partly by risk aversion.

However, this explanation for the behavior does offer a potential solution. Local REITs could be created for very small geographic areas designed to help young households who want to insure against price increases in a specific neighborhood but do not yet want to take the large risks of buying a house. They could even be metro area REITs that are heavily weighted in a particular submarket.

If Felix and Ryan want to get households to stop overleveraging themselves in housing debt, maybe their best option is to start looking for venture capital.