What is a 'Housing Bubble'

A housing bubble is a run-up in housing prices fueled by demand, speculation and exuberance. Housing bubbles usually start with an increase in demand, in the face of limited supply, which takes a relatively long period of time to replenish and increase. Speculators enter the market, further driving demand. At some point, demand decreases or stagnates at the same time supply increases, resulting in a sharp drop in prices -- and the bubble bursts.

BREAKING DOWN 'Housing Bubble'

A financial bubble refers to a situation where there is a relatively high level of trading activity on a particular asset class at price levels that are significantly higher than their intrinsic values. In other words, a bubble occurs when certain investments are bid up to prices that are far too high to be sustainable in the long run.

Traditionally, housing markets are not as prone to bubbles as other financial markets due to large transaction and carrying costs associated with owning a house. However, a combination of very low interest rates and a loosening of credit underwriting standards can bring borrowers into the market, fueling demand. A rise in interest rates and a tightening of credit standards can lessen demand, causing the housing bubble to burst.

The U.S. Housing Bubble

The infamous U.S. housing bubble in the mid-2000s was partially the result of another bubble, this one in the technology sector.

During the dotcom bubble of the late 1990s, many new technology companies had their common stock bid up to extremely high prices in a relatively short period of time. Even companies that were little more than startups and had yet to produce actual earnings were bid up to large market capitalizations by speculators attempting to earn a quick profit. By 2000, the Nasdaq peaked, and as the technology bubble burst, many of these formerly high-flying stocks came crashing down to drastically lower price levels.

As investors abandoned the stock market in the wake of the dotcom bubble bursting and subsequent stock market crash, real estate values began to rise.

Over the next six years, the mania over homeownership grew to alarming levels as interest rates plummeted, and strict lending requirements were all but abandoned.

It is estimated that 56% of home purchases during that period were made by people who would not have been able to afford them under normal lending requirements. These people were dubbed subprime borrowers. The vast majority of loans were adjustable-rate mortgages with low initial rates and a scheduled reset for three to five years.

Like the tech bubble, the housing bubble was characterized by an initial increase in housing prices due to fundamentals, but as the bull market in housing continued, many investors began buying homes as speculative investments.

The government’s encouragement of broad homeownership induced banks to lower their rates and lending requirements, which spurred a home-buying frenzy that drove prices up by 50% to 100% depending on the region of the country. The home-buying frenzy drew in speculators who began flipping houses for tens of thousands of dollars in profits in as little as two weeks. It is estimated that, during the period of 2005 to 2007, when housing prices reached their peak, as much as 30% of the valuation was supported by speculative activity.

During that same period, the stock market began to rebound, and interest rates started to tick upward. Adjustable-rate mortgages began resetting at higher rates as signs that the economy was slowing emerged in 2007. With housing prices teetering at lofty levels, the risk premium was too high for investors, who then stopped buying houses.

When it became evident to home buyers that home values could actually go down, housing prices began to plummet, triggering a massive sell-off in mortgage-backed securities. Housing prices would eventually decline more than 40% in some regions of the country, and mass mortgage defaults would lead to millions of foreclosures over the next few years.

To learn more, check out Why Housing Market Bubbles Pop.

Are We in Another Housing Bubble?

The bursting of the housing bubble sent the United States into the worst recession in decades. But as the economy recovered, so did housing prices. According to the U.S. Census Bureau, the average price of a new home sold in March 2009 was $259,800, while the median price was $205,100. In August 2017, the average price of a new home sold was $368,100, and the median price was $300,200.

The sharp increase has many people worried we're in another housing bubble. By definition, if there is a bubble, then it will eventually burst. If it doesn’t, then it wasn’t a bubble to begin.

The laws of supply and demand say there are two ways for prices to increase: Demand must increase or supply must decrease. What we saw a decade ago was demand increasing due to easy access to credit. Today, we see demand increasing due to lack of supply growth. The number of homes being built and going on the market hasn’t increased with the number of people wanting to buy a home. The result is that home prices increase.

Sam Khater, CoreLogic’s deputy chief economist, puts it this way: “Just because you’re overvalued doesn’t mean you’re in a bubble or there is an impending crash.”

So, while houses may be overvalued, the fact that supply has remained low should prevent a rapid decrease in housing prices.

Right now, interest rates are still low. However, as interest rates go higher, being able to afford a house won’t be an option for as many people. Thus, demand will shrink, and housing prices will level off or drop. If all goes well, that diminished demand won’t disrupt the market because of the tight supply. Steady growth is good for the economy, rapid rises and falls are not.

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