Real Estate Bubble

A real estate bubble is an increase in the price of housing that occurs uncorrelated to factors such as wages, employment, construction costs, land value, and interest rates. This paper will explore the forces that converge to create a real estate bubble and the effects it has on the housing market in which it occurs. Such an analysis will help the reader better understand the elements that contributed to the global economic crisis of 2008–2010 and how those elements can adversely impact the marketplace. A brief discussion of housing costs in the 2020s will be discussed.

Keywords: Community Reinvestment Act; Housing Bubble; Mortgage Rates; Negative Amortization; Real Estate; Recession; Shadow Banking; Subprime Lending

Overview

The 1920s were one of the most important decades in modern US history. As the nation began to transition from the wartime economy of World War I to a peacetime economy, it entered a period of major prosperity. The introduction of new technologies, combined with a growing entrepreneurial spirit, charged the stock markets and spawned many "rags-to-riches" stories. However, the wealth of the "Roaring 20s" was not distributed evenly, and the economy had become dependent on the stock market. In 1929, the very source of America's wealth in the 1920s collapsed, and the era of the Great Depression began. The famed American industrialist J. Paul Getty later reflected on the 1920s, saying that the "Roaring Twenties were the period of that Great American Prosperity which was built on shaky foundations" (www.brainyquote.com).

In many cases throughout history, the promise of a significant return has usually outweighed the potential risks, at least in the minds of those who engage in such activities. Such a mentality has fueled the stock market for decades, even after the cautionary example set by the infamous market crash that ended the Roaring 20s and ushered in the Great Depression. Since that era, stock market booms powered by speculative investing have been quickly reversed in recessions of varying severity. In some cases, such economic boom times have immediately followed recessions.

As the United States attempted to return to economic strength following the recession of 2001–2002, the federal government began strongly encouraging Americans to engage in a particular type of extremely risky investment. The government understood that an increased volume of real estate purchases meant more jobs (for construction workers and real estate professionals), more local and state tax revenues, and greater financial assets for the new homeowner. It set out to prod more lower-income residents to take advantage of so-called "subprime" mortgages and record-low interest rates. The result was a surge in the real estate marketplace.

Unfortunately, this increase also fostered an unexpected increase in the price of real estate. Government and lenders alike turned a blind eye to this housing "bubble," allowing it to grow larger and, like a child's balloon, more fragile as it expanded. When the bubble collapsed, it led to one of the worst recessions since the Great Depression. This paper will explore the forces that converge to create a real estate bubble and the effects this concept has on the market in which it occurs. Such an analysis will help the reader better understand the elements that contributed to the global economic crisis of 2008–2010 and how those elements can adversely impact the marketplace. Insight into rising housing prices in the 2020s will be briefly discussed.

Further Insights

The Basis for the Bubble

A real estate bubble is an uncorrelated increase in the price of housing. Housing price increases and decreases can usually be correlated to a number of factors, such as wages, employment, construction costs, property value, and, as mentioned earlier, interest rates (Bourassa, Hendershott & Murphy, 2001). When housing prices increase, but that upward trend cannot be attributed to any of these factors (or any combination thereof), a real estate bubble may be occurring. This paper will explore the housing bubble, whose collapse led to the 2007–2010 global economic crisis.

It has long been accepted that home ownership is the American dream. In fact, many world leaders have stressed to their societies the virtues of home ownership. The National Association of Realtors has written that President Franklin Delano Roosevelt once said that a nation of homeowners is "unconquerable." Several decades later, British Prime Minister Margaret Thatcher moved nearly two million families living in public housing into their own homes, saying that homeowners become responsible citizens (cited in Pisillo, 2010). Indeed, for most people, the idea of owning a home is a dream worth pursuing.

For many people, nonetheless, home ownership is an unattainable dream. Those with low income, poor credit, or other financial issues are not typically in a position to make a sizable down payment and/or enter into a long-term mortgage as well as keep up with their other bills. Still, governments emphasize the value of owning a home, which brings with it tax credits, assets that increase in value, more flexibility in obtaining loans to reduce bills, and, of course, the pride that goes with ownership. Naturally, the potential benefits of increased home ownership volumes to the local, state, and national economies are also contributors to the government's endorsement of real estate transactions.

The Community Reinvestment Act

To bridge the gulf between less affluent residents and the pursuit of home ownership, the US government introduced the Community Reinvestment Act (CRA) in 1977. As part of an effort to eliminate discrimination in lending, the CRA required that banks target a portion of their loans toward low-income and racially concentrated communities (Holyoke, 2004). Some observers see the CRA as the catalyst for the growth of low-income-oriented mortgages, a highly risky venture for lenders. Others shy away from blaming the CRA for contributing to that trend, citing its value as a piece of public policy that levels the playing field (Aalbers, 2009). Regardless of the accuracy of either argument, what is clear is that the CRA was significant in indentifying low-income residents as potential homeowners.

The Recession of 2007–2010

In December 2008, the National Bureau of Economic Research, a private group of leading economists, announced that the United States had been in a recession for one year. The main culprit, experts argued, was a decline in housing prices that had begun in 2006 (Isidore, 2008). This sudden drop in prices had an immediate impact on the stock markets, nearly leveled the financial industry, and spread throughout the world. The recession was one of the worst in US history since the Depression. Political leaders eventually reacted with efforts to prop up the financial industry and restore growth, but the root of the recession—the housing bubble and its collapse—launched an international debate.

Put simply, a real estate bubble is an increase in housing prices that is not connected to other signs of economic growth. As its name suggests, such a phenomenon is not a persistent, long-term condition. The bubble will ultimately collapse upon itself unless another element of the economy takes place to support it, such as an increase in jobs or a significant reduction in the federal deficit. The real estate bubble that led to the recession of 2007–2010 is complex in terms of the myriad factors that drove it, some of which date back to the 2001–2002 recession and the economic slowdown it created.

Contributing Factors

Interest Rates

The first of these factors was interest rates. While other elements of the economy, such as the stock market and other interest-bearing investment activities, became stagnant in the 2001 recession, housing prices continued on an upward trend, demonstrating a shift of individual investment toward real estate (Lin & Schmidt, 2002). Many economists believe that this upward growth in prices was attributed to the insistence of the Federal Reserve (the Fed) to keep interest rates low. Low interest rates can and often do spur more investments in real estate and, in turn, more economic growth in general. Such policies were quite useful in addressing the fiscal issues that abounded from 2001 to 2004 ("Economists' views," 2010). However, when the economy recovered from that period of recession, the Fed kept rates at extremely low levels, which helped prompt more people to enter into mortgages and bolster the growing bubble.

Economists disagree on the extent to which low interest rates contributed to the housing bubble, although they do agree that it did play a role. One solution that some experts proffer in the event of a housing bubble, however, is raising interest rates. Then again, such policies could in fact help foster a recession, reducing one economic danger while creating another (Labonte, 2007). Furthermore, such a solution would only be viable when a housing bubble has already occurred, and predicting a real estate bubble is a difficult challenge.

Credit Availability

A more significant contributor to a real estate bubble is the expansion of available credit. As suggested earlier, the federal government had made it its policy to encourage home ownership for every income-level resident. The area of the American population that was underachieving in this activity was the low-income segment. Many people in this category lived in debt or had poor credit, giving them perceived rather than actual resources to enter into a mortgage.

To drive this segment of the population to enter the real estate market, lenders began offering "subprime" mortgages. These loans were underwritten with more relaxed standards, such as higher debt-to-income ratios, lower credit scores, 100 percent financing, and loans permitting negative amortization (a situation in which the loan payment for any period is less than the interest charged for that period, creating a deferred interest scenario). Many experts point to the field of subprime lending as the most impactful element of the 2007-2010 recession (Roberts, 2009).

Subprime lending practices represented a relaxed financing approach to mortgages. The quality of these mortgages, however, was steadily deteriorating for several years, going nearly unregulated by the federal government. Lenders were increasingly part of a "shadow banking system" that included investment banks, hedge funds, and structured investment vehicles. These groups and their mortgages were securitized by Fannie Mae and Freddie Mac, enabling and encouraging more people to obtain such mortgages (Holt, 2009).

Government Policy

Another major contributor to the creation of the 2007 real estate bubble was government policy. As stated earlier, the federal government (since the 1970s) has encouraged individuals of all income brackets to pursue the American Dream of home ownership. Then again, subprime lending is fraught with risks, as the practice involves providing, in many cases, hundreds of thousands of dollars to individuals whose respective income and/or credit status may prevent making long-term payments. Nevertheless, the government, including the Fed, took steps to encourage low-income residents to purchase homes. Among these steps were making home mortgage interest tax deductible and reminding homeowners that they could use the expected equity of those mortgages to pay off bills, take vacations, purchase new cars, and make other purchases (Kohn & Bryan, 2010). In fact, the government even relaxed its standards for lending practices, letting subprime lenders offer even more enticing mortgage programs, such as interest-only loans and loan-to-value loans, both of which required little to no checks on income or credit status. With the government focusing on increasing the number of real estate purchases, the responding volume of mortgages contributed heavily to the growing housing bubble.

Interest rates, subprime lending, and loose regulations are contributing factors to real estate bubbles. However, these elements may not have been alone in driving housing prices upward. It may take some time to determine the complete group of factors that contributed to the housing bubble that created the global financial crisis of 2007–2010. Some believe, for example, that restrictive land-use policies, such as those found in greater Boston, push up housing prices more than in markets like greater Houston, where development is not as restricted (Razzi, 2010). Others suggest that a contributing factor was the fact that, although government regulations protecting against risky investments like subprime lending were in place, the government simply failed to enforce them, allowing a greater number of home buyers to assume such mortgages (Stiglitz, 2009). Still others point to the widespread use of hybrid adjustable rate mortgages (ARMs), under which buyers agree to a low introductory interest rate and thus lower payments that later balloon (Thode & Culp, 2013). Some believe that the weak negotiating position of first-time buyers, a group comprising most subprime mortgagees, helped push housing prices higher, as weak buyers generally pay more for their homes (Thode & Culp, 2013).

Viewpoints

Those who assert that there may be other causes of the housing bubble that have to date gone unnoticed are joined by others who believe that many of the perceived causes of the housing bubble may, in fact, be erroneous. For example, according to Henderson, the assertion that the Fed was pushing to keep interest rates low is not an accurate one. While the government certainly welcomed the low rates, these rates held for so long because of the savings introduced to the economy from other countries (Henderson, 2009). In fact, this argument makes sense when analyzing the low-interest rates that contributed to housing bubbles in other countries—shortly before the crisis, many of the nations that experienced a housing bubble had also experienced savings that lowered interest rates.

Also compounding the issue is the fact that housing bubbles are often difficult to detect as they develop. Indeed, the development of a national real estate bubble was not on the mind of Fed Chairman Alan Greenspan in 2005 when he was asked about increases in housing prices. Of the national system, he said that he noticed only "a little froth," suggesting that there were only localized bubbles, not a national one (Leonhardt, 2005). His misreading of the growing issue, one that (to his credit) was shared by many other leading economists, was illustrative of both the nebulous character of housing bubbles and the severe consequences of disregarding them.

In 2022, signs that another real estate bubble was forming became concerning. The housing market exploded with sales from 2021 through 2022 due to a surge in mortgage rates. By 2023, interest rates were high but buyer demand had slowed and housing prices began to decline. While economists kept their eye on issues affecting a real estate bubble, changes put into place after the recession of 2007-2008 provided a safeguard against a repeat of that housing crisis (Campisi & Rothstein, 2023).

Conclusion

What should have been a beautiful addition to a twelfth-century Italian cathedral actually became one of the largest architectural blunders in history. The building was constructed on a foundation of sand, clay, and shells, after all—it is therefore no mystery that what was hoped to be a magnificent component of the Cathedral of Pisa would instead suffer a reputation as its "Leaning Tower."

Like the Leaning Tower and the Roaring Twenties, housing bubbles are built on unstable foundations. While economists often differ on the causes of specific bubbles, they generally agree that bubbles occur in such a way that they are unsustainable. The housing bubble that led to the global financial crisis of 2007-2010 had its roots in a number of issues, such as low interest rates, an expansion of credit, a lack of regulatory safeguards, and a lack of enforcement of existing regulations.

It was also the result of an active government push for a new segment of the U.S. population to seek out and purchase real estate. Previously, home ownership was believed to be an activity that only the middle and upper classes could pursue. Beginning with the CRA in the 1970s, however, the government stressed to all residents the notion that home ownership was not an unfeasible goal. This push gave rise to the subprime lending field. Reckless disregard for the enormous risks it entails was the major culprit in fostering the 2007-2010 recession and the global crisis that accompanied it.

The subsequent recession also demonstrated the challenges posed for policymakers and government officials in the detection of real estate bubbles as well as gauging their severity. Many believe that the government was blinded by its success in driving more people to purchase homes and, as a result, failed to notice the growing national housing bubble. Additionally, incidents like Alan Greenspan's "frothy" comment, which left him open to great criticism, underscore the confusion housing bubbles can cause.

Most experts believe that housing bubbles deserve continued study, particularly in light of the damages the national real estate bubble helped reap on the US economy over a three-year period.

Terms & Concepts

Community Reinvestment Act: A 1977 law that required banks to offer mortgages to low-income and racially-concentrated communities.

Housing Bubble: An increase in the price of housing that occurs uncorrelated to factors such as wages, employment, construction costs, land value, and interest rates.

Negative Amortization: A situation in which the loan payment for any period is less than the interest charged for that period, creating a deferred interest scenario and ultimately greater debt.

Shadow Banking: Lending activity that is conducted by investment banks, hedge funds, and structured investment vehicles rather than through traditional lending institutions.

Subprime Lending: The practice of offering home mortgages to individuals with low incomes and/or poor credit.

Bibliography

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Suggested Reading

Bone, J., & O'Reilly, K. (2010, June). No place called home: The causes and social consequences of the UK housing 'bubble'. British Journal of Sociology, 61, 231–255.

Holcombe, R., & Powell, B. (Eds). (2009). Housing America: Building out of a crisis. New Brunswick, NJ: Transaction.

Seiders, D. (2006, September 13). Housing bubble and the economy. FDCH Congressional Testimony. Retrieved September 5, 2010 from EBSCO Online Database Newspaper Source Plus.

Peláez, R. (2012). The housing bubble in real-time: The end of innocence. Journal of Economics & Finance, 36, 211–225. Retrieved November 10, 2014 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=72339783

Somerville, G. (2010, April 8). Housing bubble not Fed's fault, Greenspan testifies. Toronto Star. Retrieved September 5, 2010 from EBSCO Online Database Newspaper Source Plus.

White, L. (2009). Federal Reserve policy and the housing bubble. CATO Journal, 29, 115–125. Retrieved September 5, 2010 from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=39771741&site=ehost-live.