Why Housing Market Bubbles Pop - Investopedia

Housing bubbles are temporary periods of months or years characterized by high demand, low supply, and inflated prices above fundamentals. · These bubbles are ... TableofContents Expand TableofContents WhatIsaHousingBubble? CausesofHousingMarketBubbles ForcesthatBursttheBubble The2007–08HousingMarketCrash MeanReversion PriceAppreciationEstimates TheBottomLine AlternativeInvestments RealEstateInvesting Unlikethestockmarketwherepeopleunderstandandaccepttheriskthatpricesmayfallfromtimetotime—sometimesseverely—manypeoplewhobuyahousedonotreallythinkthatthevalueoftheirhomewilleverdecreasebyallthatmuch. Indeed,historically,thehousingmarkethasnotbeenaffectedbypricebubbleswhencomparedwithotherassetclasses.Thatcouldbedueinparttothelargetransactioncostsassociatedwithpurchasingahome,nottomentionthecarryingcostsofowningandmaintainingahome—allofwhichdiscouragespeculativebehavior.However,housingmarketsdosometimesgothroughperiodsofirrationalexuberanceandseepricesriserapidlybeforefallingbackinline. Inthisarticle,we'lldiscussthecausesofhousingpricebubbles,thetriggersthatmakehousingbubblesburst,andwhyhomebuyersshouldlooktolong-termaverageswhenmakingcriticalhousingdecisions. KeyTakeaways Housingbubblesaretemporaryperiodsofmonthsoryearscharacterizedbyhighdemand,lowsupply,andinflatedpricesabovefundamentals.Thesebubblesarecausedbyavarietyoffactorsincludingrisingeconomicprosperity,low-interestrates,widermortgageproductofferings,andeasytoaccesscredit.Forcesthatmakeahousingbubblepopincludeadownturnintheeconomy,ariseininterestrates,aswellasadropindemand. 1:23 WatchNow:WhatIsaHousingBubble? WhatIsaHousingBubble? Beforegettingintothecausesofhousingbubblesandwhatmakesthemgopop,itisimportanttounderstandahousingbubbleinandofitself.Thesegenerallybeginwithajumpinhousingdemand,despitealimitedamountofinventoryavailable. Demandfurtherincreaseswhenspeculatorsenterthemarket,makingthebubblebiggerastheysnapupinvestmentpropertiesandfixer-upperflips.Withlimitedsupplyandsomuchnewdemand,pricesnaturallyrise. Housingbubbleshaveadirectimpactontherealestateindustry,butalsoonhomeownersandtheirpersonalfinances.Theimpactabubblecanhaveontheeconomy(e.g.,oninterestrates,lendingstandards,andsecuritizationpractices)canforcepeopletofindwaystokeepupwiththeirmortgagepaymentswhentimessuddenlyturnandgettough.Somemayevenhavetodigdeeperintotheirpockets,usingsavingsandretirementfundsjusttokeeptheirhomes.Otherswillgobankruptandforeclose. Anybubbleisnormallyjustatemporaryevent.Althoughbubblesintheequitymarketscanhappenmorefrequently,housingbubblescanpersistformuchlonger,accordingtotheInternationalMonetaryFund(IMF),andcanlastseveralyears. CausesofHousingMarketBubbles Thepriceofhousing,likethepriceofanygoodorserviceinafreemarket,isdrivenbythelawofsupplyanddemand.Whendemandincreasesorsupplydecreases,pricesgoup.Intheabsenceofsomenaturaldisaster,whichcandecreasetheimmediatesupplyofhomes,pricesrisewhendemandtendstooutpacesupplytrends.Thesupplyofhousingcanalsobeslowtoreacttoincreasesindemandbecauseittakesalongtimetobuildorfixupahouse,andinhighlydevelopedareastheresimplyisn'tanymorelandtobuildon.So,ifthereisasuddenorprolongedincreaseindemand,pricesaresuretorise. Onceitisestablishedthatanabove-averageriseinhousingpricesisinitiallydrivenbyademandshock,wemustaskwhatthecausesofthatincreaseindemandare.Thereareseveralpossibilities: Ariseingeneraleconomicactivityandincreasedprosperitythatputsmoredisposableincomeinconsumers'pocketsandencourageshomeownership Anincreaseinthepopulationorthedemographicsegmentofthepopulationenteringthehousingmarket Alow,generallevelofinterestrates,particularlyshort-terminterestrates,thatmakeshomesmoreaffordable Innovativeornewmortgageproductswithlowinitialmonthlypaymentsthatmakehomesmoreaffordabletonewdemographicsegments Easyaccesstocredit—oftenwithlowerunderwritingstandards—thatalsobringsmorebuyerstothemarket High-yieldingstructuredmortgage-backsecurities(MBS),asdemandedbyWallStreetinvestorsthatmakemoremortgagecreditavailabletoborrowers Potentialmispricingofriskbymortgagelendersandmortgagebondinvestorsthatexpandtheavailabilityofcredittoborrowers Theshort-termrelationshipbetweenamortgagebrokerandaborrowerunderwhichborrowersaresometimesencouragedtotakeexcessiverisks Alackoffinancialliteracyandexcessiverisk-takingbymortgageborrowers. Speculativeandriskybehaviorbyhomebuyersandpropertyinvestorsfueledbyunrealisticandunsustainablehomepriceappreciationestimates. Anincreaseinhomeflipping. Eachofthesevariablescancombinewithoneanothertocauseahousingmarketbubbletotakeoff.Indeed,thesefactorstendtofeedoffofeachother.Adetaileddiscussionofeachisoutofthescopeofthisarticle.Wesimplypointoutthatingeneral,likeallbubbles,anuptickinactivityandpricesprecedesexcessiverisk-takingandspeculativebehaviorbyallmarketparticipants—buyers,borrowers,lenders,builders,andinvestors. ForcesthatBursttheBubble Thebubblefinallyburstswhenexcessiverisk-takingbecomespervasivethroughoutthehousingsystemandpricesnolongerreflectanythingclosetofundamentals.Thiswillhappenwhilethesupplyofhousingisstillincreasinginresponsetothepriordemandspike.Inotherwords,demanddecreaseswhilesupplystillincreases,resultinginasharpfallinpricesasnobodyislefttopayforevenmorehomesandevenhigherprices. Thisrealizationofriskthroughoutthesystemistriggeredbylossessufferedbyhomeowners,mortgagelenders,mortgageinvestors,andpropertyinvestors.Thoserealizationscouldbeprecipitatedbyanumberofthings: Anincreaseininterestratesthatputshomeownershipoutofreachforsomebuyersand,insomeinstances,makesthehomeapersoncurrentlyownsunaffordable.Thisoftenleadstodefaultandforeclosure,whicheventuallyaddstothecurrentsupplyavailableinthemarket. Adownturningeneraleconomicactivitythatleadstolessdisposableincome,jobloss,orfeweravailablejobs,whichdecreasesthedemandforhousing.Arecessionisparticularlydangerous. Demandisexhausted,bringingsupplyanddemandintoequilibriumandslowingtherapidpaceofhomepriceappreciationthatsomehomeowners,particularlyspeculators,countontomaketheirpurchasesaffordableorprofitable.Whenrapidpriceappreciationstagnates,thosewhocountonittoaffordtheirhomesmaylosetheirhomes,bringingmoresupplytothemarket. Thebottomlineisthatwhenlossesmount,creditstandardsaretightened,easymortgageborrowingisnolongeravailable,demanddecreases,supplyincreases,speculatorsleavethemarket,andpricesfall. The2007–08HousingMarketCrash Inthemid-2000s,theU.S.economyexperiencedawidespreadhousingbubblethathadadirectimpactonbringingontheGreatRecession.Followingthedotcombubble,valuesinrealestatebegantocreepup,fuelingariseinhomeownershipamongspeculativebuyers,investors,andotherconsumers.Low-interestrates,relaxedlendingstandards—includingextremelylowdownpaymentrequirements—allowedpeoplewhowouldotherwiseneverhavebeenabletopurchaseahometobecomehomeowners.Thisdrovehomepricesupevenmore. Butmanyspeculativeinvestorsstoppedbuyingbecausetheriskwasgettingtoohigh,leadingotherbuyerstogetoutofthemarket.Indeed,itturnedoutthatwhentheeconomytookaturnfortheworse,awholelotofsubprimeborrowersfoundthemselvesunabletopaytheirmonthlymortgages.This,inturn,causedpricestodrop.Mortgage-backedsecuritiesweresoldoffinmassivequantities,whilemortgagedefaultsandforeclosuresrosetounprecedentedlevels. Mortgagelendingdiscriminationisillegal.Ifyouthinkyou'vebeendiscriminatedagainstbasedonrace,religion,sex,maritalstatus,useofpublicassistance,nationalorigin,disability,orage,therearestepsyoucantake.OnesuchstepistofileareporttotheConsumerFinancialProtectionBureauorwiththeU.S.DepartmentofHousingandUrbanDevelopment(HUD). MeanReversion Toooften,homeownersmakethedamagingerrorofassumingrecentpriceperformancewillcontinueintothefuturewithoutfirstconsideringthelong-termratesofpriceappreciationandthepotentialformeanreversion. Thelawsofphysicsstatethatwhenanyobject—whichhasadensitygreaterthanair—ispropelledupward,iteventuallyreturnstoearthbecausetheforcesofgravityactuponit.Thelawsoffinancesimilarlystatethatmarketsthatgothroughperiodsofrapidpriceappreciationordepreciationwill,intime,reverttoapricepointthatputstheminlinewithwheretheirlong-termaverageratesofappreciationindicatetheyshouldbe.Thisisknownasreversiontothemean. Pricesinthehousingmarketfollowthistendencyformeanreversion,too.Afterperiodsofrapidpriceappreciation,orinsomecases,depreciation,theyreverttowheretheirlong-termaverageratesofappreciationindicatetheyshouldbe.Homepricesmeanreversioncanbeeitherrapidorgradual.Homepricesmaymovequicklytoapointthatputsthembackinlinewiththelong-termaverage,ortheymaystayconstantuntilthelong-termaveragecatchesupwiththem. U.S.HousingPriceIndex ThetheoreticalvalueshownabovehasbeenderivedbycalculatingtheaveragequarterlypercentageincreaseintheHousingPriceIndexfromthefirstquarterof1985throughthefourthquarterof1998—theapproximatepointatwhichhomepricesbegantoriserapidlyabovethelong-termtrend.ThecalculatedaveragequarterlypercentageincreasewasthenappliedtothestartingvalueshowninthegraphandeachsubsequentvaluetoderivethetheoreticalHousingPriceIndexvalue. PriceAppreciationEstimates Toomanyhomebuyersuseonlyrecentpriceperformanceasbenchmarksforwhattheyexpectoverthenextseveralyears.Basedontheirunrealisticestimates,theytakeexcessiverisks.Thisexcessiverisk-takingisusuallyassociatedwiththechoiceofamortgage,andthesizeorcostofthehometheconsumerpurchases. Thereareseveralmortgageproductsthatareheavilymarketedtoconsumersanddesignedtoberelativelyshort-termloans.Borrowerschoosethesemortgagesbasedontheexpectationtheywillbeabletorefinanceoutofthatmortgagewithinacertainnumberofyears,andtheywillbeabletodosobecauseoftheequitytheywillhaveintheirhomesatthatpoint. Recenthomepriceperformanceisnot,however,generallyagoodpredictionoffuturehomepriceperformance.Homebuyersshouldlooktolong-termratesofhomepriceappreciationandconsiderthefinancialprincipleofmeanreversionwhenmakingimportantfinancingdecisions.Speculatorsshoulddothesame. Whiletakingrisksisnotinherentlybadand,infact,takingrisksissometimesnecessaryandadvisable,thekeytomakingagoodrisk-baseddecisionistounderstandandmeasuretherisksbymakingfinanciallysoundestimates.Thisisespeciallyapplicabletothelargestandmostimportantfinancialdecisionmostpeoplemake—thepurchaseandfinancingofahome. TheBottomLine Asimpleandimportantprincipleoffinanceismeanreversion.Whilehousingmarketsarenotassubjecttobubblesassomemarkets,housingbubblesdoexist.Long-termaveragesprovideagoodindicationofwherehousingpriceswilleventuallyendupduringperiodsofrapidappreciationfollowedbystagnantorfallingprices.Thesameistrueforperiodsofbelow-averagepriceappreciation. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. InternationalMonetaryFund."AssessingtheRiskoftheNextHousingBust."AccessedJan.9,2022. TheWhiteHouse."HelpingResponsibleHomeowners."AccessedJan.9,2022. BoardofGovernorsoftheFederalReserveSystem."TheRiseinMortgageDefaults,"Page2.AccessedJan.9,2022. BoardofGovernorsoftheFederalReserveSystem."AgencyMortgage-BackedSecurities(MBS)PurchaseProgram."AccessedJan.9,2022. U.S.DepartmentofHousingandUrbanDevelopment-OfficeofPolicyDevelopmentandResearch."ReporttoCongressontheRootCauseoftheForeclosureCrisis,"Pages3-13.AccessedJan.9,2022. U.S.DepartmentofHousingandUrbanDevelopment."HousingDiscriminationUndertheFairHousingAct."AccessedJan.9,2022. FederalHousingFinanceAgency."FHFAHousePriceIndex."AccessedJan.9,2022. RelatedArticles HomeEquity WhatIstheAverageEquityinU.S.Homes? ReverseMortgage WhyDon'ttheBigBanksOfferReverseMortgagesorHELOCs? Macroeconomics TheGreatRecession'sImpactontheHousingMarket PortfolioConstruction ExplainingRisingInterestRatesandRealEstatetoClients Markets 5StagesofABubble Markets AssetBubblesThroughHistory:The5Biggest PartnerLinks RelatedTerms Froth Frothreferstomarketconditionsprecedinganactualmarketbubble,whereassetpricesbecomedetachedfromtheirunderlyingintrinsicvalues. more LearnAboutaBubbleinEconomics Abubbleisaneconomiccyclethatischaracterizedbyarapideconomicexpansionfollowedbyacontraction. more WhatIsaHousingBubble? Ahousingbubbleisarun-upinhomepricesfueledbydemand,speculation,andexuberance,whichburstswhendemandfallswhilesupplyincreases. more WhatIsanUnderwaterMortgage? Anunderwatermortgageisahomepurchaseloanwithahigherprincipalthanthefree-marketvalueofthehome. more SubprimeMeltdown Thesubprimemeltdownincludestheeconomicandmarketfalloutfollowingthehousingboomandbustfrom2007to2009. more WhatIstheFirst-TimeHomebuyerTaxCredit? Thefederalfirst-timehomebuyertaxcreditwasendedin2010butthereareotherstateandfederalprogramsdesignedtoencouragehomeownership. more