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 extended period to replenish and increase. Speculators pour money into the market, further driving up 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.

Key Takeaways

  • A housing bubble a sustained but temporary condition of over-valued prices and rampant speculation in housing markets.
  • The U.S. experienced a major housing bubble in the 2000s caused by inflows of money into housing markets, loose lending conditions, and government policy to promote home ownership.
  • A housing bubble, as with any other bubble, is a temporary event and could even happen again.

Understanding Housing Bubble

A housing bubble is a temporary event, but it can last for years. Usually, it’s driven by something outside the norm such as demand, speculation, high levels of investment, or excess liquidity—all of which can cause home prices to become unsustainable. It leads to an increase in demand versus supply. According to the International Monetary Fund (IMF), housing bubbles may be less frequent than equity bubbles, but they tend to last twice as long.

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 particular investments are bid up to prices that are far too high to be sustainable in the long run.

Housing bubbles don't only affect the real estate industry, but also have a significant effect on people of all classes, neighborhoods, and the overall economy. They can force people to look for ways to pay off their mortgages through different programs or may have them dig into retirement accounts to afford to live in their homes. Housing bubbles have been one of the main reasons why people end up losing their savings.

What Causes a Housing Bubble?

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

Mid-2000 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. It was directly related to the financial crisis of 2007-2008

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, they moved their money into real estate. At the same time the U.S. Federal Reserve cut interest rates and held them down in order to combat the mild recession that followed the technology bust, as well as to assuage uncertainty following the World Trade Center attack of 9/11/2001. This flood of money and credit met with various government policies designed to encourage home ownership and a host of financial market innovations that increased the liquidity of real estate related assets. Home prices rose, and more and more people got into the business of buying and selling houses.

Over the next six years, the mania over home ownership grew to alarming levels as interest rates plummeted, and strict lending requirements were all but abandoned. It is estimated that 56 percent 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 home ownership induced banks to lower their rates and lending requirements, which spurred a home-buying frenzy that drove prices up by 50 to 100 percent 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 percent of the valuation was supported by speculative activity.

During that same period, the stock market began to rebound, and by 2006 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 percent in some regions of the country, and mass mortgage defaults would lead to millions of foreclosures over the next few years.

Are We in Another Housing Bubble?

The bursting of the housing bubble precipitated a financial crisis and 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 June 2019, the average price of a new home sold was $368,600, and the median price was $310,400. The sharp increase has many people worried we're in another housing bubble. By definition, if there is a bubble, it will eventually burst. If it doesn’t burst, then it wasn’t a bubble at all.