Housing Bubble

Definition and Causes of Housing Bubbles

A bubble in the price of an asset occurs when the market price of the asset is substantially higher than the fundamental economic value of the asset. Joseph Stiglitz defines asset bubbles as follows: “If the reason that the price is high today is only because investors believe that the selling price will be high tomorrow—when ‘fundamental’ factors do not seem to justify such a high price—then a bubble exists” (1990, p. 13). Owner-occupied housing is fundamentally a consumption good with an uncertain cost. The cost is uncertain because future house prices are unknown. If the price of a house increases between the time a home buyer purchases a residence and the time the homeowner sells the residence, then the cost of owning the home is lower than it would have been if house prices were constant over the holding period. Similarly, if the price of a home [Page 340]decreases between the purchase and subsequent sale, then the cost of homeownership is higher compared to a holding period with constant house prices. When a potential home buyer decides to purchase a house, the buyer must form some expectation of what future house prices are likely to be. Karl Case and Robert Shiller acknowledge the important role that expectations play in the determination of house prices in their definition of house price bubble:

The most important cause of house price bubbles is home buyers’ (and mortgage lenders’) unrealistic expectations of future real house price appreciation. But what causes the initial real increase in house prices that eventually results in unrealistic expectations of continued house price appreciation? The most important factor during the recent house price bubble was the dramatic increase in the supply of mortgage credit. According to the Federal Reserve System's Flow of Funds Account, outstanding residential mortgage debt in the United States more than doubled between 2000 and 2007—from $4,798.4 million to $10,540.2 million (Figure 1).

Figure 1 U.S. Mortgage Debt (in trillions $)

Along with the increase in the supply of mortgage credit came lax underwriting standards (where borrowers did not have to provide evidence of their income or their assets), zero equity loans, and excessively risky mortgage instruments such as payment option adjustable rate mortgages (where the interest rate used to compute the monthly mortgage payment is substantially below the rate used to accrue interest on the outstanding mortgage balance).

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