What Is the Housing Bubble? Definition, Causes and Recent Example

What Is a Housing Bubble?

A housing bubble, or real estate bubble, is a run-up in housing prices fueled by demand, speculation, and exuberant spending to the point of collapse. 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 has the potential to happen at any time market conditions allow it.

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Understanding a 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 manipulated demand, speculation, unusually high levels of investment, excess liquidity, deregulated real estate financing market, or extreme forms of mortgage-based derivative products—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.

Housing bubbles don't only cause a major real estate crash, 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, and what some consider the cause of, 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 Sept. 11, 2001.

This flood of money and credit met with various government policies designed to encourage homeownership 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 homeownership grew to alarming levels as interest rates plummeted, and strict lending requirements were all but abandoned. It is estimated that 20 percent of mortgages in 2005 and 2006 went to people who would not have been able to qualify under normal lending requirements. These people were dubbed subprime borrowers. Over 75 percent of these subprime loans were adjustable-rate mortgages with low initial rates and a scheduled reset after two to three years. 

Much like with 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 the median sales price of homes up by 55 percent from 2000 to 2007. 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.

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 decline 19 percent from 2007 to 2009, and mass mortgage defaults would lead to millions of foreclosures over the next few years.

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  1. International Monetary Fund. "World Economic Outlook April 2003: Growth and Institutions," Download "Chapter II: When Bubbles Burst," Pages 68-69. Accessed Sept. 27, 2020.

  2. Board of Governors of the Federal Reserve System. "Open Market Operations Archive." Accessed Sept. 27, 2020.

  3. Joint Center for Housing Studies of Harvard University. "The State of the Nation's Housing 2008," Page 2. Accessed Sept. 27, 2020.

  4. Board of Governors of the Federal Reserve System. "The Rise in Mortgage Defaults," Page 5. Accessed Sept. 27, 2020.

  5. U.S. Financial Crisis Inquiry Commission. "Financial Crisis Inquiry Report," Pages 84-92. Accessed Sept. 27, 2020.

  6. FRED Economic Data. "Median Sales Price of Houses Sold for the United States." Accessed Sept. 27 2020.

  7. Freddie Mac. "30-Year Fixed-Rate Mortgages Since 1971." Accessed Sept. 27, 2020.

  8. Federal Reserve Bank of Chicago. "Have Borrowers Recovered from Foreclosures during the Great Recession?" Accessed Sept. 27, 2020.