CCSS3 Unit 9 Housing Bubbles

WHY HOUSING MARKET BUBBLES POP

By Barry Nielsen

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?