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.

RELATED TERMS
  1. Speculative Bubble

    A speculative bubble is a spike in asset values within a particular ...
  2. Bubble

    1. An economic cycle characterized by rapid expansion followed ...
  3. Foreclosure Prevention Act of 2 ...

    A housing act that is designed to help families keep homes that ...
  4. Herd Instinct

    A mentality characterized by a lack of individual decision-making ...
  5. Depressed

    A state or condition of a market, product or security characterized ...
  6. Open House

    An open house is a scheduled period of time in which a house ...
Related Articles
  1. 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.
  2. Tech

    Is the Cryptocurrency Bubble More Like Housing or Dotcom?

    Many investors believe cryptocurrencies are a bubble phenomenon, but which historical bubble does it resemble?
  3. Insights

    Some Industries Are More Bubbly Than Others

    Investors who want to avoid future bubbles should learn from the past in order to protect their investments.
  4. 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.
  5. Investing

    A Bond Bubble: CFAs Say We're in One

    Almost 90% of CFAs think the bond market is in bubble territory, a recent poll has found.
  6. Tech

    Bitcoin and Altcoins: Are There 2 Crypto-Bubbles?

    If bitcoin and altcoins are separate markets, it could mean there are two different bubbles.
  7. Insights

    What Causes Bubbles?

    A look at how asset bubbles are formed according to different schools of thought.
  8. Investing

    Where Will the Shanghai Composite Be in a Year?

    The Shanghai Composite Index is on fire. But where will it be a year from now?
  9. Small Business

    Why Social Media Isn't Like The Dotcom Boom

    Many investors see social media stocks as a bubble waiting to burst. Find out why they're wrong.
  10. Managing Wealth

    4 Reasons Why the Housing Recovery Will Be Short-lived (LOW, HD)

    Evidence would suggest that the same culprits from 2008 and some new ones are re-inflating a housing bubble.
RELATED FAQS
  1. Can the Efficient Market Hypothesis explain economic bubbles?

    Learn about the nuanced relationship between the efficient market hypothesis and economic bubbles and the requirements and ... Read Answer >>
  2. What are the typical factors that cause the economy to repeat a boom and bust cycle?

    Read about the fundamental causes of the economic boom-bust cycle, why some recessions are necessary and why asset bubbles ... Read Answer >>
  3. 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 >>
  4. How has investing in the Internet sector evolved over time?

    Learn how early investors of the Internet sector received a valuable lesson and influenced modern-day markets after the dot-come ... Read Answer >>
  5. 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. Bubble

    1. An economic cycle characterized by rapid expansion followed by a contraction. 2. A surge in equity prices, often more ...
  2. Swap

    A swap is a derivative contract through which two parties exchange financial instruments, such as interest rates, commodities, ...
  3. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  4. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  5. Risk Tolerance

    The degree of variability in investment returns that an individual is willing to withstand. Risk tolerance is an important ...
  6. Donchian Channels

    A moving average indicator developed by Richard Donchian. It plots the highest high and lowest low over the last period time ...
Trading Center