A housing bubble is one of several types of asset price bubbles in which housing prices are full of demand, speculation, and vigorous spending to the point of collapse. To elaborate, the housing bubble consists of two phases. The first phase is where the speculators drive the prices of the houses, they increase the price drastically. The second phase occurs when the house prices are increased at such a level that the demand decreases and the prices collapse i.e., they fall drastically. The housing bubble has the largest effect on the real economy.
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What Is Housing Bubble?
A housing bubble is an event that consists of exuberant spending and speculation of housing prices. Due to an increase in demand the house prices keep on rising to such a level that reverses the situation i.e., the demand decreases and the house prices fall drastically.
- Although the housing bubble is a temporary event, it has a large impact on the economy which can last for a longer period of time.
- The most common drivers for the unsustainable rise in the housing price are manipulated demand, speculation, high level of investment, unregulated real estate financing market, and different forms of mortgage-based derivatives product.
- The housing bubble not only impacts real estate but also impacts the people of different classes, neighborhoods, cost of living. To summarize, the housing bubble impacts the overall economy.
What Are The Causes Of The Housing Bubble?
- The housing bubble is caused due to an unsustainable rise in demand. Such a rise is caused due to an increase in the credit lending and charging of very low interest rates along with a loosening of credit underwriting standards.
- As lowering of the interest rates increases the demand. The rising of the interest rates and tightening the credit standards will lead to lowering the demand. This will cause the housing bubble to burst I.e., the prices will collapse drastically.
How It Led To The 2007-08 Housing Market Crash
- In the early 2000s, investors were looking for securities that were safe and would provide good returns. Equities and bonds were good alternatives but due to the uncertainty of the firm being bankrupt, investors started focusing on mortgages.
- Mortgages are the loans taken to buy a new house. They are similar to bonds, where the lenders get regular interest payments, and once the borrower defaults the lenders become the owners of the borrower’s house.
- Instead of buying individual mortgages, the investor started buying mortgage-backed securities provided by the investment banks. The investment banks buy large quantities of mortgages from the lenders and sell those shares to the pool of investors as mortgage-backed securities. Meaning, the homebuyers pay investors the mortgage payments.
- Later, the demand for mortgage-based securities increased drastically and was never-ending. Not only investment banks but also the government started to boost mortgage lending. Lenders were facing an endless demand for mortgages. To compete with the banks, the insurance company started the credit default swaps in which the speculators invested heavily.
- Due to the increasing demand, the lender then started giving loans to borrowers with low income and bad credit scores. Even though the subprime loan had a low interest on mortgages they were extremely risky. Soon due to the loosening of credit underwriting standards everyone started taking loans even if they didn’t have enough capital to pay off the mortgage. Investment banks are accepting whatever the lenders provide them without performing any proper expertise.
- Soon the subprime borrowers started to default. By October 2007, 3% of home loans are in closing down the process and 7% are past due. Mortgage investments were turning into real estate and investment banks are supplying the market with foreclosed homes.
- The supply increased and the demand for mortgage-based securities fell. By 2008, the housing prices collapsed. This led to the rising of the domino effect that was the 2008 financial crisis.
- The banks, lenders, insurers started to shut down. Governments tried saving the major players of the economy. By September, the US faced the largest bankruptcy in history. Countries in a tie-up with the US were affected. Many people lost their jobs. The whole economy was affected drastically.
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A housing bubble is an event that occurs due to an unsustainable rise in house prices which later collapses. Such type of scenario was the major contributor to the 2007-08 financial crisis. The effect of the housing bubble lasts for a longer period as it affects the economy. Investors should perform proper due diligence before investing in a security and organizations should be mindful of investor’s interests.
Author – Divyashri Kadam
About The Author – Divyashri is a Bachelor’s Degree Holder in Accounting and Finance. Also, a Certified Financial Modeling and Valuation Analyst (FMVA). She is enthusiastic to learn more about financial markets, financial analysis, and anything relating to stocks.