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  • Housing bubbles are sharp price increases driven by a temporary surge in demand that isn't rooted in basic fundamentals.
  • Fundamentals are determined by the factors that affect supply and demand, such as costs of building houses and changes in population demographics.
  • Though experts often disagree on the existence of a housing bubble, you can look at housing prices compared to rent and income as a good indicator.
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In the 90s and early 2000s, loose lending standards and subprime mortgages led to a housing bubble that devastated families across the US, particularly those in the middle class. Housing prices are now higher than they were at the peak of the housing bubble, yet experts disagree on whether this price spike can be considered a bubble. 

If a price spike in the housing market doesn't necessarily indicate a housing bubble, what is a housing bubble and how does it form? 

What is a housing bubble?

A housing bubble is a sharp price increase in the real estate market as a result of a sudden, and temporary surge in demand caused by external factors. According to Housing Wire lead analyst Logan Mohtashami, housing bubbles occur when "prices are disconnected from fundamentals, and the demand that's being pushed by housing is in a speculative nature." 

Housing bubbles are defined by their ability to "pop." Eventually, whatever is driving demand will collapse, and suddenly there is no demand, which means that housing prices will begin dropping rapidly. 

Let's take an example: the housing bubble in the mid-2000s. At that time, lending standards were incredibly slack, and it was easy to get a housing loan, which created unsustainable demand for housing. When credit standards tightened, demand shrunk and prices fell.

Compared to other economic bubbles, housing bubbles are uncommon. This is primarily because housing is so expensive, and so it's not subject to a great deal of impulsiveness. 

"It is very hard to have a massive marketing campaign that goes viral, that makes everybody want to suddenly change this fundamentally huge decision in your life that has so many steps, and so much interaction with credit and loans and banks, " says Skylar Olsen, principal housing economist at Tomo, a digital real estate firm. "It's not like the Beanie Baby craze." Maintaining a house is also costly in both time and money, which discourages speculation. 

What causes a housing bubble?

There is no one cause for a housing bubble — it varies from bubble to bubble. However, they're always caused when the housing market moves away from the fundamentals that it's based on, usually by some temporary external pressure on the housing market that boosts demand.

The housing bubble that crashed housing prices in the 2000s was a result of subprime mortgages or loose lending practices, what Mohtashami calls exotic loan debt structures. These risky loans were given to borrowers who wouldn't have been able to buy a house otherwise, opening the possibility of home ownership to a whole section of the population. Unfortunately, many of these borrowers were unable to make their mortgage payments, so they lost their homes as credit standards tightened.

"We no longer have any exotic loan debt structures in the system," Mohtashami says. "Hence, we have created the best homeowner loan profiles ever in our history."

Speculation can further drive the housing market away from fundamentals, though it doesn't have the force to create a housing bubble on its own. When real estate prices start climbing, speculators might see an opportunity to ride that wave and buy into the real estate market. These property investors limit the housing supply and raise prices even higher and further away from the fundamentals. Speculation pushes more housing construction which makes the crash worse when the bubble pops by creating supply overhang, which further devalues homes.

In debates about a current housing bubble in 2022, a housing bubble would be caused by the Federal Reserve Board boosting the economy during the pandemic. "If you're arguing bubble right now, what you would be arguing is that the Fed was something artificial," Olsen says. "They had revved up the economy too much, too hard, and now they have to pull back. That's the process of potentially popping the bubble."

What are housing market fundamentals?

If the market moving away from fundamentals causes a housing bubble, this begs the question: What are the fundamentals of the housing market?

Like all markets, the housing market is driven by supply and demand. Housing supply can be influenced by factors such as construction prices, land availability, even new construction technology. Housing supply is thought to be elastic in the long run, which means it can adjust to meet demand over a long period of time. However, this is increasingly less true. 

Supply can also be affected by housing destruction. "I think that's worth talking about, especially as we approach climate change," Olsen says. "You can lose a bunch of homes during a hurricane or with storm surge."

On the other hand, housing demand is largely driven by the demographics of the people buying houses. This includes the age of the people buying houses and the income of these people. Demand is also impacted by the type of employment and where people want to migrate. "Big job booms, or industry booms within a metropolitan area will attract higher earning jobs. Higher earning income ends up increasing the ability of people to pay in the market," Olsen says.

Demand will also be affected by the location of the housing market. Looking at something on a smaller scale, like a city, demand can be affected by school districts and crime rates. 

How to determine if we're in a bubble

Though defining a bubble and its potential causes is easy enough, determining if we are actually in a housing bubble is tricky. Housing experts often disagree on whether a price spike is caused by a shift in fundamentals — so not a housing bubble — or something that's completely divorced from these fundamentals. 

Research economist Luis Torres writes in a Texas AM study that "home prices growing at a rapid rate is not in itself conclusive evidence of a bubble." Instead, these price increases are "not based on economic fundamentals, especially if price increases for that region do not reflect overall historical price trends." 

Additionally, because fundamentals change over time so "there is no safe way of knowing what prices should be," Torres writes. There's no way to determine when the market is acting abnormally, because there's no normality to compare it to. 

However, it can be helpful to compare other economic trends against housing prices like the cost of rent. If rent is increasing alongside housing prices, there might just be a migration wave moving to a certain area or perhaps demand for housing is just going up. Olsen says "there might be something inappropriate in home values if they grow so much faster than rents, right?"

Additionally, another concerning indicator is if housing prices are rapidly outpacing income. Housing demand grows when income grows because people have more disposable income for a down payment on a house. If income isn't growing but housing prices are, then something else other than buying power is pushing demand. 

The mid-2000s housing bubble explained

The housing bubble that popped in 2008 was a culmination of several bad practices in the housing market that took place over several years. 

Mortgage-backed securities: Mortgage-backed securities (MBS) were a type of investments that grouped together mortgages and sold them to investors on the secondary market. They are only as secure as the mortgages themselves, which in the 2000s, meant they weren't very secure, but investors had no idea because risk wasn't being assessed properly. 

When MBSs moved into the primary market, which meant investors were buying directly from lenders, "you had a bunch of mortgage lenders who found it easy to lend because they have this stream of money," Olsen says. 

Adjusted-rate mortgages: Low mortgage rates increase real estate demand by making houses accessible to more people who wouldn't have been able to purchase a house otherwise. In the 2000s, a large portion of mortgages were adjustable-rate mortgages. These entice people with an initial low mortgage rate that increases after the initial rate period expires. Olsen says that households that took out an adjustable-rate mortgage didn't understand or weren't told exactly how much their mortgage rate might change. "They were given a loan that they could not really pay off," she says.

Rising mortgage rates caused a wave of foreclosures, which doubled from nearly 720,000 in 2006 to 2.3 million in 2008. Six trillion dollars was lost in wealth as a result of the housing crash. 

Credit is now incredibly tight. "It's never been harder to get a loan to buy a home," Shah says. As a result, it's unlikely that we'll see a housing bubble caused by these same circumstances. If we want to keep it that way, Mohtashami says "the best thing for America is to never ease lending standards from where they are right now, and everything will be okay."

Paul Kim is a Personal Finance fellow at Insider where he writes explainers and how tos that help readers understand how to better manage their money. A recent NYU graduate, Paul has spent the majority of his journalism career at his student-run newspaper Washington Square News, where he wore a number of hats. Most recently, he helped rebuild the newspaper in the spring of 2021 as its managing editor after nearly all the staff resigned the previous semester over issues of editorial independence.When he's not writing, Paul loves cooking and eating. He hates cilantro. Direct tips to pkim@insider.com and family recipes to @PaulKimWrites on Twitter.

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