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What Is A Housing Bubble And How Does It Work?

Last updated 04/08/2024 by

Jordan Berg

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Housing bubbles stem from an above-average surge in home demand, where prices rise quicker than normal. This happened during the housing market crash in 2007-08, where mortgage lenders practiced predatory lending tactics and offered mortgages to borrowers that could not afford the monthly payments.
If you’ve followed the news over the past year or so, you’ve probably heard talk about a potential housing bubble in the U.S. economy. Or maybe, like me, you’re curious about the Great Recession that arose from the 2007–08 housing market crash. How do real estate bubbles collide with financial markets?
A housing bubble is a real estate phenomenon in which the housing market’s limited supply cannot meet surging housing demand. This overinflates the housing market, which can prevent people from purchasing a new home. If this barrier grows too quickly, the bubble bursts, making home prices fall and sending ripple effects throughout the economy.

What is a housing bubble?

A housing bubble is a period in the real estate market where the housing supply cannot meet demand, pushing home and real estate prices above normal levels. Typically, once homeowners and home seekers can no longer afford the above-average rise, prices fall, and the housing bubble pops.

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Housing bubbles explained

Imagine that you’re in the bathtub. You pour soap onto your palm, then blow on it, causing a small bubble to grow. The more air you blow, the bigger it gets. The problem is that bubbles burst. If you blow too much air, the bubble can no longer support all the air inside, so eventually, it explodes.
Housing bubbles work similarly.

What forms the bubble?

If more people seek housing than the housing market—the bubble—can provide, home prices—the air in the bubble—rise. People become excited that their (future) property will increase in value because that means more money in their pockets. They are likely to see their (future) home as an investment, so they purchase a new house or make home improvements, thinking it will give them a nice financial return in the future. They then tell their friends, who spread the optimism and expectation of making money in real estate.
As the news catches on, momentum drives people to further invest, as everyone believes their actions will pay dividends down the line. Speculators, thrilled to make a profit, notice the upward trend and jump in on the action, driving home price appreciation to a breaking point.

When does the bubble burst?

If too many people do this at the same time, the above-average price for homes rises faster than people can pay. Housing supply starts to catch up with demand. However, since these high home prices are no longer affordable to most people, demand suddenly decreases.
When this happens at once, the bubble, unable to support itself, finally bursts. There are too many homes at prices people are unwilling to pay, causing their own homes to lose value.
If this happens in our soap illustration, you’re just stuck in the bathtub out of breath, with soap all over your hand. Unfortunatley, when a housing bubble bursts, people can lose their homes and life savings.

What causes a housing bubble?

There is no single cause for a housing bubble to occur, but there are a few common factors that encourage it.

1.) Economic stability

Although a housing bubble may not sound like a stable phenomenon, having disposable income certainly is. When people feel they’re on solid ground, they spend money. More spending means more cash flowing through the stock market and society at large. The faster it flows, the more often it touches people excitedly looking to profit, such as speculative buyers. Speculation exacerbates the speed at which the real estate bubble expands.
When people have an optimistic outlook on their economic future, the societal effects are contagious: positivity begets positivity. This means there is a clear human psychological element of excitement that feeds into producing real estate bubbles.

2.) Low interest and mortgage rates

People borrow more money when interest rates are low because it costs less. In other words, loans are “cheap.” This affects the housing market as people seek mortgage lenders to borrow money at a lower cost than normal.
Low interest rates set an economic baseline for a real estate bubble to occur: money is easier to attain, so people borrow it to finance their new house or make home improvements. As these people flood the real estate market, home prices rise, and additional people rush to join. This pressure builds to create housing bubbles.

3.) Weak lending standards in real estate

Housing bubbles typically evolve from substandard mortgage lending practices. Seeing an opportunity to make money in the housing market, mortgage lenders engage in risky behavior such as predatory lending, giving loans to people without checking their ability to repay, and not educating customers on the nuances of complicated products like adjustable-rate mortgages.
This lack of lending standards was a hallmark of the real estate bubble that created the 2007-08 housing market crash. When the mortgage lender’s incentive is to make money at any cost—including misleading customers and not performing due diligence—a housing bubble is more likely to occur.

Ultimately, a bubble forms and explodes

Economic stability, low interest and mortgage rates, and weak real estate lending standards all set the foundation for housing bubbles. While these three factors are critical, they aren’t exclusive circumstances.
Housing bubbles are unique events prodded by economic and social complexities that are oftentimes too difficult to see as they take place. However, it is easy to recognize them in hindsight once demand decreases, and the dust settles from the real estate industry and the larger economy.

The 2007–08 housing market crash

Perhaps the most infamous case of a housing bubble in recent memory is the 2007–08 housing market crash. It is a cautionary tale of the horrific consequences of not checking home buyers’ potential to repay home loans.

How did this crash begin?

Following a period of high growth in the 1990s, the US economy hit a snag at the turn of the century.
Somewhat like the housing bubbles discussed here, the Dotcom Tech Bubble of the 90s was fueled by investor excitement in nascent software technology. Start-ups with little to no actual revenue potential received millions of dollars in funding and became highly overvalued. The tech bubble burst when investors realized that the new companies would not live up to their promises. Although this touched investors in the space, it had limited effect on home buyers or personal finance at large.
The September 11th attacks were also extremely traumatic for the nation’s psyche. While they sharply decreased general consumer optimism, they did not alter housing prices.

Mid-2000s housing bubble

As the U.S. recovered from the Dotcom bust and 9/11 attacks, the US housing market took off at a rapid pace. The U.S. Federal Reserve Bank presided over historically low interest rates, spurring above-average growth. Mortgage companies began lending money to too many borrowers without verifying the borrowers’ income, jobs, or assets (colloquially, NINJA loans).
Suddenly millions more people, known as subprime borrowers, were offered mortgage payments at temporarily discounted rates. As the excitement caught on, demand for homes began to inflate a housing bubble.
The Federal Reserve lowered interests rates from 2001 to 2004 to spur growth, then raised rates to curb inflation.
Homebuyers, now flush with more cash as their home values grew, saw opportunities to invest in (new) properties. People raced to secure equity in what became a housing boom.
High demand for properties encouraged home buyers and many owners to invest in the housing market.
Amidst the unusual growth, investment companies, hedge funds, and speculators saw an opportunity to profit from what they figured would be continual price appreciation. They encouraged a credit expansion that contained predatory lending practices, but for a time, home values continued to rise. The Federal Reserve even raised interest rates to combat inflation.
The 2007–08 housing market crash was unique in its brazenness, as borrowers were lent money without lenders having a clue if borrowers could repay the loans. Subprime lending was perhaps the biggest cause of the real estate bubble. It would be completely unsustainable for borrowers without any income to meet their monthly mortgage payments if their homes were to lose any value, and once their adjustable rates rose after the first few years. Unfortunately, that is precisely what happened.

The housing crash

By 2007, it was clear that home prices were overvalued, and housing markets were likely to take a hit. The U.S. was officially in a housing bubble and began to recognize some of its implications.
Many subprime mortgages, first shielded due to low initial rates and down payments, started to fail. Subprime borrowers could no longer meet their monthly bills, and mortgage defaults caused real estate prices to drop as homeowners foreclosed on their properties.
The U.S. experienced significant home price appreciation until peaking in 2006. When the housing bubble exploded, prices fell for the next 5 years.
Even with falling prices and the housing bubble rupturing, the stock market continued to climb. It wasn’t until the U.S. government took over failing mortgage companies Fannie Mae and Freddie Mac, and Lehman Brothers’s collapse in September 2008, that the world took notice of the scope of the problem at hand.

Ramifications of the housing market collapse

What began as a housing bubble issue quickly became an international financial crisis.
By 2008, the real estate industry and money markets were so interconnected, and their products so complex, that the collapse of the housing bubble loomed over much of the world economy. House prices and home sales tanked, while some of the largest players in the global financial system required takeovers by governments and larger banks. The mayhem caused prices to fall even further. The U.S. and many other countries entered into what became the Great Recession. Millions of people lost their jobs, homes, and savings—a process that continued for years after the collapse.
Over a decade later, the U.S. economy and sociopolitical environment remain scarred from the housing market crash. While mortgage lenders are now required to follow more stringent underwriting procedures, a generation of people who came of age during the Great Recession are mired in debt partly due to potential lost earnings.

Are we in a housing bubble now?

As of now (April 2022), there is some concern that the U.S. is experiencing a housing bubble once again.

Housing prices rise

The onset of the COVID-19 pandemic in March 2020 brought the housing market to a stop. However, the U.S. government quickly stepped in and provided financial aid to millions of Americans. With so many consumer outlets closed and people working from home, Americans saved money. Since the pandemic began, the U.S. housing market has risen by nearly $10 trillion in value.
Although housing took a hit at the onset of the pandemic, it has since recovered dramatically, leading some experts to question the unusual growth.
Many Americans have invested in real estate. The combination of accelerated economic growth and rise in housing prices has caused concern there may be a housing bubble similar to the one that caused the 2007-08 market crash.
U.S. home prices climbed considerably after a brief dip in early 2020.
Despite some apprehension, the chances of another housing bubble seem doubtful at the moment.

Why a housing bubble is unlikely for now

As a result of the Great Recession, mortgage companies can no longer provide subprime home loans to borrowers. The inability of the latter to pay their mortgages was a foundation of the 2007-08 crisis.
Furthermore, the previous housing crash was accelerated by a boom in housing construction, which itself was enabled by inexpensive construction costs. The current holdups in supply chains, and general price appreciation across the globe, have driven home improvement costs up, preventing the real estate supply boom that made the 2007-08 problem possible.
Expensive construction costs from inflation and supply chain issues may prevent the U.S. from experiencing a housing bubble.
However, currently, it’s too difficult to tell if the U.S. is in the midst of a real estate bubble. With the Federal Reserve recently raising interest rates, a housing bubble is improbable, but certainly not impossible.

Key Takeaways

  • A housing bubble is an above-average rise in house prices due to too much home demand for too little home supply.
  • Housing bubbles occur in environments of economic stability, low interest and mortgage rates, and weak real estate lending standards.
  • When a housing bubble pops, real estate values fall due to an inflated housing supply and decreasing housing demand.
  • The 2007-08 real estate crash was largely caused by subprime mortgage lending and speculative investor behavior, deeply wounding global and personal finance.
  • In the spring of 2022, it’s unlikely, but not impossible, that the U.S. is in the midst of a housing bubble.

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