The question is being asked with increasing frequency, and also with great anxiety. The last housing bubble led to a financial crisis followed by a recession.
Many of those commenting on the question, however, don't understand what a price bubble is. It is NOT a marked rise in prices. Sharp price increases are common, and pose no threat to the stability of the economy whereas price bubbles are rare and do pose a threat.
A price bubble is a rise in price based on the expectation that the price will rise. Sooner or later something happens to erode confidence in continued price increases, at which point the bubble bursts and prices drop. What makes it a price bubble is that the cause of the price increase is an expectation that the price will increase, which sooner or later must reverse itself.
Bubbles can only arise in markets where the stock of items is very large relative to new production. If a rise in price immediately stimulates an increase in supply, any bubble will quickly disappear. Housing meets that condition because the stock of houses is large relative to new construction, but ocean liners have an even longer production cycle than houses, and to my knowledge that industry has never been hit by a price bubble. Something else must be involved and it is quite possible that there is no single explanation.
The expectations of price increases that drove the house price bubble of 2000-2006, which led to the financial crisis, was not limited to consumers looking to buy houses. It also engulfed the lenders who financed their house purchases, and the investors here and abroad who purchased the securities that were issued against home mortgage collateral. Indeed, they were the crucial players in the bubble.
Rising home prices convert virtually all mortgage loans, even those that violate the most sacrosanct underwriting rules, into good loans. For example:
- The borrower with an adjustable rate mortgage can't meet the new higher payment on the first rate adjustment date in two years. No problem, after two years of price increase, the house will then have enough equity to allow the lender to refinance the loan with a new lower payment.
The borrower has no money for a down payment. No problem, after two years of five percent price increases, the borrower will have equity of more than 10 percent. The borrower is a poor credit risk with a high likelihood of defaulting. No problem if he defaults, the price increases will cover the foreclosure costs and we'll get our money back.The presumption that house prices could only rise was supported by a long record of house price increases interrupted by only occasional declines in specific areas that were moderate and short-lived. Prior to 2006, there had not been a national decline in house prices since the depression of the 1930s. The premise that this pattern would continue was entirely plausible -- so much so that it was generally accepted by regulators who did nothing to deflate the bubble. Wholesale acceptance by lenders, investors and regulators of the premise that house prices could only rise led to the bubble, which invalidated the premise when the bubble burst -- as all bubbles do.
House prices generally fell between 2006 and 2012, and have been on the rise since 2012, with the increases in some areas bringing prices above the highs reached in 2006. Reports of large price increases are now invariably accompanied by concerns about whether or not another bubble may be brewing.
My view is that we are a long way from another house price bubble. Home buyers, lenders, investors and regulators now understand that a nationwide decline in house prices is possible -- because we recently lived through one. Probably it will take another generation to forget what we learned.
Even if the lesson was forgotten tomorrow, changes that have occurred in the housing finance system as a result of the crisis and the recession would make it very difficult if not impossible for the system to support a bubble. Among the more important changes:
- Appraisals tend to err on the low side today, rather than on the high side as was the case during the bubble.
Alternative documentation rules that allowed many borrowers to qualify without adequate financial capacity, are gone; full documentation is the rule. The private secondary market in mortgage-backed securities, which financed most of the sub-prime mortgages written during the bubble period, collapsed during the crisis and has barely begun to recover. In many respects, these changes went too far and made the housing finance system less effective, but they did eliminate the threat of another housing bubble. I don't expect to see another one in my lifetime.
For more articles on the mortgage marketplace, or to compare mortgage offerings from multiple lenders in a fair, unbiased environment please visit my website
The Mortgage Professor
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