WHY HOUSING MARKET BUBBLES POP
In this article, we'll discuss what causes
housing price bubbles, the triggers that cause housing bubbles to burst and why
home buyers should look to long-term averages when making critical housing
decisions.
Mean Reversion
Too often, homeowners make the
damaging error of assuming recent price performance will continue into the
future without first considering the long-term rates of price appreciation and
the potential for mean reversion. The laws of physics state that when any object is propelled upward,
it will return to earth because of the forces of gravity act upon it. The laws of finance say that markets that
go through periods of rapid price appreciation or depreciation will, in time,
revert to a price point that puts them in line with where their long-term
average rates of appreciation indicate they should be. This is known as mean
reversion.
Prices in the housing market follow this law of mean reversion too -
after periods of rapid price appreciation (or depreciation), they revert to
where their long-term average rates of appreciation indicate they should be.
Home price mean reversion can be rapid or gradual. Home prices might fall (or
rise) quickly to a point that puts them back in line with the long-term
average, or they might stay constant until the long-term average catches up
with them.
The
Causes of a Housing Market Bubble
The price of housing, like the price of any good or service in a free market,
is driven by supply and demand. When demand increases and/or supply decreases,
prices go up. In the absence of a natural disaster that might decrease the
supply of housing, prices rise because demand trends outpace current supply
trends. Just as important is that the supply of housing is slow to react to
increases in demand because it takes a long time to build 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 you've established that an above-average rise in housing prices is
primarily driven by an increase in demand, you might ask what the causes of
that increase in demand are. There are several:
1. An upturn in general economic activity and prosperity that puts more disposable income in consumers' pockets and encourages home ownership.
2. An increase in the population or the demographic segment of the
population entering the housing market.
3. A low general level of interest rates, particularly short-term interest rates, that makes homes more affordable.
4. Innovative mortgage
products with low initial monthly payments that make homes more affordable.
5. Easy access to credit
(a lowering of credit-granting standards) that brings more buyers to market.
6. High-yielding
structured mortgage bonds, as demanded by investors that make more mortgage
credit available to borrowers.
7. A potential mispricing of risk by mortgage lenders and mortgage bond
investors that expands the availability of credit to borrowers.
8. The short-term relationship between a mortgage broker and a borrower
under which borrowers are sometime encouraged to take excessive risks.
9. A lack of financial literacy and excessive risk-taking by mortgage
borrowers.
10. Speculative and risky behavior by home buyers and property investors
fueled by unrealistic and unsustainable home price appreciation estimates.
The Forces that Cause
the Bubble to Burst
The bubble bursts when excessive risk-taking becomes pervasive throughout the
housing system. This happens while the supply of housing is still increasing. In other words, demand decreases
while supply increases, resulting in a fall in prices.
This
pervasiveness of risk throughout the system is triggered by losses suffered by homeowners,
mortgage lenders, mortgage investors and property investors. Those losses could
be triggered by a number of things, including:
1. 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, leading to default and foreclosure, which eventually adds to supply.
2. A downturn in general economic activity that leads to less disposable
income, job loss and/or fewer available jobs, which decreases the demand for
housing.
3. Demand is exhausted, bringing supply and demand into equilibrium and
slowing the rapid pace of home price appreciation that some homeowners,
particularly speculators, count on to make their purchases affordable or
profitable. When rapid price appreciation stagnates, those who count on it to
afford their homes long term might lose their homes, bringing more supply to
the market.
The bottom line is that
when losses mount, credit standards are tightened, easy mortgage borrowing is
no longer available, demand decreases, supply increases, speculators leave the
market and prices fall.
Conclusion
A simple and important principle of finance is mean reversion. While housing
markets are not as subject to bubbles as some markets, housing bubbles do
exist. Long-term averages provide a good indication of where housing prices
will eventually end up during periods of rapid appreciation followed by
stagnant or falling prices. The same is true for periods of below average price
appreciation.
SUMMARY:
DEFINITION of 'Housing Bubble'
A run-up in housing prices
fueled by demand, speculation and the belief that recent history is an
infallible forecast of the future. Housing bubbles usually start with an
increase in demand (a shift to the right in the demand curve), in the face of
limited supply which takes a relatively long period of time to replenish and
increase. Speculators enter the market, believing that profits can be made
through short-term buying and selling. This further drives demand. At some
point, demand decreases (a shift to the left in the demand curve), or stagnates
at the same time supply increases, resulting in a sharp drop in prices - and
the bubble bursts.
INVESTOPEDIA EXPLAINS 'Housing
Bubble'
Traditionally, housing markets
are not as prone to bubbles as other financial markets due to large transaction
and carrying costs associated with owning a house. However, a combination of
very low interest rates and a loosening of credit underwriting standards can
bring borrowers into the market, fueling demand. A rise in interest rates and a
tightening of credit standards can lessen demand, causing a housing bubble to
burst. Other general economic and demographic trends can also fuel and burst a
housing bubble.
Questions
1. What is “mean reversion”?
2. What is a housing market bubble?
3. What causes a housing bubble?
4. What can cause the increase in demand that causes a
housing bubble?
5. Why does the bubble burst?
6. What can trigger the losses that cause the bubbles to
burst?
7. What is a good predictor of where housing prices will
eventually end up?
