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'

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 housing bubble was long in forming as real estate values began to rise in response to investors abandoning the stock market in the wake of the dotcom bubble and the 2000 stock market crash. 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 otherwise would not be able to afford them under normal lending requirements. They were dubbed subprime borrowers. The vast majority of loans were adjustable-rate mortgages with a low initial rate and a scheduled reset for three to five years.

Government-Induced Frenzy

The government’s encouragement of broad homeownership induced banks to lower their rates and requirements which spurred a home buying frenzy that drove prices up by 50 to 100% depending on the region of the country. The 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 percent of the valuation was supported by speculative activity.

What Goes Up Must Come Down

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.

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