What Is a Housing Bubble? Definition, Causes, and Example – Investopedia

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What Is a Housing Bubble?

A housing or real estate bubble is a run-up in housing prices fueled by demand, speculation, and exuberant spending. It can lead to the point of collapse.

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Housing bubbles usually start with an increase in demand in the face of limited supply. It takes a relatively extended period to replenish and increase. Speculators will further drive up demand by pouring money into the market. Demand decreases or stagnates at some point as supply increases and this results in a sharp drop in prices. Then the bubble bursts.

Key Takeaways

  • A housing bubble is 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 homeownership.
  • A housing bubble is a temporary event.
  • A bubble can potentially happen whenever market conditions allow it.

Understanding Housing Bubbles

A housing bubble is a temporary event but it can last for years. It’s usually driven by something outside the norm, such as manipulated demand, speculation, unusually high levels of investment, excess liquidity, a deregulated real estate financing market, or extreme forms of mortgage-based derivative products. All these factors can cause home prices to become unsustainable and this leads to an increase in demand versus supply.

Housing bubbles don’t just cause a major real estate crash. They 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 various programs or they may have them digging into retirement accounts to afford to continue living in their homes. Housing bubbles have been one of the main reasons why people end up losing their savings.

Housing bubbles may be less frequent than equity bubbles but they tend to last twice as long, according to the International Monetary Fund (IMF).

What Causes a Housing Bubble?

Housing markets aren’t traditionally 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. This can fuel demand.

A rise in interest rates and a tightening of credit standards can lessen demand, causing the housing bubble to burst.

The Mid-2000 U.S. Housing Bubble

The infamous U.S. housing bubble that occurred in the mid-2000s was partially the result of another bubble in the technology sector. It was directly related to the financial crisis of 2007-2008 and some consider it to be the cause of that crisis.

Many new technology companies had their common stock bid up to extremely high prices in a relatively short period during the dot-com bubble of the late 1990s. 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. The Nasdaq peaked by 2000 and many of these formerly high-flying stocks came crashing down to drastically lower price levels as the technology bubble burst.

Investors moved their money into real estate as they abandoned the stock market in the wake of the dot-com bubble bursting and the subsequent stock market crash. The U.S. Federal Reserve cut interest rates at the same time and held them down to combat the mild recession that followed the technology bust and to assuage uncertainty following the World Trade Center attack of Sept. 11, 2001.

This flood of money and credit was 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.

The mania over homeownership grew to alarming levels as interest rates plummeted over the next six years. Strict lending requirements were all but abandoned. It’s estimated that 20% 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. More than 75% of these subprime loans were adjustable rate mortgages with low initial rates and scheduled resets after two to three years. 

The housing bubble was characterized by an initial increase in prices due to fundamentals, much like the tech bubble. But many investors began buying homes as speculative investments as the bull market in housing continued.

The government’s encouragement of broad homeownership induced banks to lower their rates and lending requirements. This spurred a home-buying frenzy that drove the median sales price of homes up by 55% 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.

The stock market began to rebound during that same time and interest rates began to tick upward by 2006.

Adjustable rate mortgages began resetting at higher rates in 2007 as signs that the economy was slowing emerged. The risk premium was too high for investors with housing prices teetering at lofty levels and they then stopped buying houses. Housing prices began to plummet when it became evident to homebuyers that home values could go down. This triggered a massive sell-off in mortgage-backed securities.

Housing prices would decline by 19% from 2007 to 2009. Mass mortgage defaults would lead to millions of foreclosures over the next few years.

What Is a Speculator in Real Estate?

A speculator buys properties because they have reason to believe that the market or some factor in the economy is going to result in an increase in value, sometimes in a short period of time. The goal is to “flip” the property and sell it as soon as this occurs, reaping a profit. Unlike a speculator, an investor anticipates more of a long-term profit due to factors other than or in addition to market volatility.

What Is an Adjustable Rate Mortgage?

The interest rate on an adjustable rate mortgage (ARM) can go up and down over time and this will affect a homebuyer’s mortgage payment, causing it to increase or decrease periodically as well. But most ARMs have rate caps and other controls in place to prevent frequent, dramatic, and painful swings.

The advantage of this type of mortgage is that the interest rate is typically less than that of a fixed rate mortgage in the early years of the loan.

What Is the Foreclosure Process?

Foreclosure can vary in its finer details from state to state, such as by imposing time constraints on when a mortgage lender can begin the process. But it’s typically initiated because the homeowner has stopped making mortgage payments.

The mortgage contract gives the lender a secured interest in the property, This provides the lender with a legal right to seize the property after giving proper notice to the homeowner and allowing them to cure the default. The lender will then sell the property to recoup some, if not all, of the money it loaned so the homeowner could initially buy the property.

The Bottom Line

A housing bubble can significantly cut into the equity you have in your home and it typically happens due to some economic factor that’s beyond your control. You may suddenly find that your mortgage balance is way more than the value of your property.

It may not be a crushing blow if you can continue paying your mortgage and you don’t have plans to move in the foreseeable future so you have time to ride the bubble out. But you may want to seek the help of a real estate professional or attorney to guide you if this isn’t not the case.

Proceed with utmost caution if you’re thinking of investing in property at a time when home values are depressed, thinking that you can sell for much more later. Housing bubbles can have long-term and dramatic effects.

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