What Is a Housing Bubble?
Before getting into the causes of housing bubbles and what makes them go pop, it is important to understand a housing bubble in and of itself. These generally begin with a jump in housing demand, despite a limited amount of inventory available.
Demand further increases when speculators enter the market, making the bubble bigger as they snap up investment properties and fixer-upper flips. With limited supply and so much new demand, prices naturally rise.
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Housing bubbles have a direct impact on the real estate industry, but also homeowners and their personal finances. The impact a bubble can have on the economy (e.g., on interest rates, lending standards, and securitization practices) can force people to find ways to keep up with their mortgage payments when times suddenly turn and get tough. Some may even have to dig deeper into their pockets, using savings and retirement funds just to keep their homes. Others will go bankrupt and foreclose.
Any bubble is normally just a temporary event. Although bubbles in the equity markets can happen more frequently, housing bubbles can persist for much longer, according to the International Monetary Fund (IMF), and can last several years.
Causes of Housing Market Bubbles
The price of housing, like the price of any good or service in a free market, is driven by the law of supply and demand. When demand increases or supply decreases, prices go up. In the absence of some natural disaster, which can decrease the immediate supply of homes, prices rise when demand tends to outpace supply trends. The supply of housing can also be slow to react to increases in demand because it takes a long time to build or fix up a house, and in highly developed areas there simply isn’t any more land to build on. So, if there is a sudden or prolonged increase in demand, prices are sure to rise.
Once it is established that an above-average rise in housing prices is initially driven by a demand shock, we must ask what the causes of that increase in demand are. There are several possibilities:
A rise in general economic activity and increased prosperity that puts more disposable income in consumers’ pockets and encourages homeownership
An increase in the population or the demographic segment of the population entering the housing market
A low, general level of interest rates, particularly short-term interest rates, that makes homes more affordable
Innovative or new mortgage products with low initial monthly payments that make homes more affordable to new demographic segments
Easy access to credit—often with lower underwriting standards—that also brings more buyers to the market
High-yielding structured mortgage bonds (MBS), as demanded by Wall Street investors that make more mortgage credit available to borrowers
A potential mispricing of risk by mortgage lenders and mortgage bond investors that expands the availability of credit to borrowers
The short-term relationship between a mortgage broker and a borrower under which borrowers are sometimes encouraged to take excessive risks
A lack of financial literacy and excessive risk-taking by mortgage borrowers.
Speculative and risky behavior by home buyers and property investors fueled by unrealistic and unsustainable home price appreciation estimates.
An increase in home flipping.
Each of these variables can combine with one another to cause a housing market bubble to take off. Indeed, these factors tend to feed off of each other. A detailed discussion of each is out of the scope of this article. We simply point out that in general, like all bubbles, an uptick in activity and prices precedes excessive risk-taking and speculative behavior by all market participants—buyers, borrowers, lenders, builders, and investors.
Forces that Burst the Bubble
The bubble finally bursts when excessive risk-taking becomes pervasive throughout the housing system and prices no longer reflect anything close to fundamentals. This will happen while the supply of housing is still increasing in response to the prior demand spike. In other words, demand decreases while supply still increases, resulting in a sharp fall in prices as nobody is left to pay for even more homes and even higher prices.
This realization of risk throughout the system is triggered by losses suffered by homeowners, mortgage lenders, mortgage investors, and property investors. Those realizations could be precipitated by a number of things:
An increase in interest rates that puts homeownership out of reach for some buyers and, in some instances, makes the home a person currently owns unaffordable. This often leads to default and foreclosure, which eventually adds to the current supply available in the market.
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