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.

RELATED TERMS
  1. Speculative Bubble

    A spike in asset values within a particular industry, commodity, ...
  2. Bubble Theory

    A school of thought that believes that the prices of assets can ...
  3. Tech Bubble

    A pronounced and unsustainable market rise attributed to increased ...
  4. Bubble

    1. An economic cycle characterized by rapid expansion followed ...
  5. Subprime Meltdown

    The sharp increase in high-risk mortgages that went into default ...
  6. Dotcom Bubble

    A rapid rise in equity markets fueled by investments in internet-based ...
Related Articles
  1. Investing

    Why Housing Market Bubbles Pop

    Home price appreciation is not assured. Can you withstand the volatility in this market?
  2. Investing

    Economic Bubble: Toil And Trouble!

    You might like the idea of profiting from a bubble, but you’d probably like to avoid suffering from its aftermath. Here is how an economic bubble works.
  3. Insights

    Should the Fed Be More Worried About Asset Bubbles?

    While the Fed should be concerned that assets bubbles might impact economic stability, monetary policy is not the best tool to mitigate this threat.
  4. Insights

    Economic Meltdowns: Let Them Burn Or Stamp Them Out?

    Whether the Fed should intervene in market bubbles is up for debate. Learn about both sides here.
  5. Insights

    How Do Asset Bubbles Cause Recessions?

    Understand how asset bubbles often lead to deep, protracted recessions. Read about historical examples of recessions preceded by asset bubbles.
  6. Insights

    5 Steps of a Bubble

    In the financial sense, a bubble refers to a situation where the price of an asset far exceeds its fundamental value.
  7. Financial Advisor

    Talking to Clients Who Think Stocks Are in a Bubble

    Here's what to tell clients who think that the market is in bubble territory.
  8. Insights

    5 Ways To Spot The Next Stock Bubble - And Avoid It

    Playing a market bubble could pay off, but it carries a lot of risk. Avoiding it could be the way to stay profitable.
  9. Investing

    6 Cities at Highest Risk for a Housing Bubble

    These global cities face a housing bubble, thanks to factors such as demand from foreign investors.
  10. Insights

    4 Reasons Why Irrational Exuberance Lasts

    20 years ago, Alan Greenspan gave his famous "irrational exuberance" speech, but asset bubbles take a long time to pop.
RELATED FAQS
  1. What is an echo bubble?

    To understand the term "echo bubble", you have to understand what a bubble is. A financial or economic bubble occurs when ... Read Answer >>
  2. When did the real estate bubble burst?

    Collapsing home prices from subprime mortgage defaults and risky investments on mortgage-backed securities burst the housing ... Read Answer >>
  3. How does the law of supply and demand affect the housing market?

    Learn about the law of supply and demand, the relationship between supply and demand and how the law of supply and demand ... Read Answer >>
  4. How does a decline in housing prices affect the banking sector?

    Learn about the affects on banks when housing prices go down, including loan delinquency rates, mortgage foreclosures, and ... Read Answer >>
Hot Definitions
  1. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
  2. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
  3. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta by investing in securities that differ from the market index ...
  4. Run Rate

    1. How the financial performance of a company would look if you were to extrapolate current results out over a certain period ...
  5. Hard Fork

    A hard fork (or sometimes hardfork) is a radical change to the protocol that makes previously invalid blocks/transactions ...
  6. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
Trading Center