Can Metropolitan Housing Risk be Diversified? A Cautionary Tale from the Recent Boom and Bust

TL;DR

This paper examines the increasing integration of US metropolitan housing markets, revealing that higher correlation reduces diversification benefits and increases risk, especially during the 2000s housing boom and bust.

Contribution

It provides new estimates of market integration, correlation, and contagion, and assesses how these factors impact diversification potential in housing investments.

Findings

High and increasing market integration over the 2000s

Reduced diversification benefits due to rising correlation

Increased risk in housing portfolios during the housing crisis

Abstract

Geographic diversification is fundamental to risk mitigation among investors and insurers of housing, mortgages, and mortgage-related derivatives. To characterize diversification potential, we provide estimates of integration, spatial correlation, and contagion among US metropolitan housing markets. Results reveal a high and increasing level of integration among US markets over the decade of the 2000s, especially in California. We apply integration results to assess the risk of alternative housing investment portfolios. Portfolio simulation indicates reduced diversification potential and increased risk in the wake of estimated increases in metropolitan housing market integration. Research findings provide new insights regarding the synchronous non-performance of geographically-disparate MBS investments during the late 2000s.