The term housing bubble has left the lexicon of the economists and become something we all know. The question is, do we understand it? The real estate market isn’t the only sector to experience bubbles but it is one of the most potentially devastating. So much of the economy is centered on the personal wealth of homeowners that any shock ripples through everything.

How Does a Bubble Develop?

A one-word explanation might be greed. Persons looking to make too much money too quickly. Of course, that’s too simplistic and doesn’t take into account all the variables. A housing bubble develops when supply overruns real demand but speculative demand continues to grow. In the first stages of growth a bubble is fed by legitimate expansion. More people needing houses and having the means to purchase them. Without regulatory or economic controls to put the brakes on near the top, the growth begins to feed upon itself. Speculation explodes. Homeowners overextend their buying power under the assumption that their equity will rise enough that a second mortgage can cover expenses. People begin to use housing as a sort of credit card, borrowing against upward equity.

Northern California is a good example of how a bubble grows beyond sustainability. The expansion can move so fast that by the time people begin to realize that they are near the top, they are already over it. Like the Gold Rush California experienced in the 1800s, everyone wanted in on the deal. As the bubble grew, some buy much more house than they could normally afford. When the most recent housing bubble occurred it was exasperated by changes in banking regulations that allowed the trading of questionable financial instruments. Trading in paper not directly tied to specific mortgages but were instead tied to bulk loans meant a lessening of accountability and led to the market being read incorrectly.

What Makes a Bubble Burst?

The nature of a bubble makes it so that it really doesn’t take that much to bring it down. In 2008, buying had started slowing down. The main reason was simple affordability. Too many people were priced out of the market. The Bay Area was a prime example. The cities had become too expensive and that bled over into the suburbs. That in turn caused the market to flinch. From there, speculation started to lose its luster. Those factors combined until they began to snowball.

Seemingly overnight, homeowners became familiar with the term underwater. They owed more on their house than it was worth. That sucked the air out of the refinance market which in turn hit consumer buying. Getting a home improvement loan or borrowing to go on a grand vacation were no longer options. Less money in the economy fed back to less people being to afford to buy a house. Repossessions became rampant and that sped up the fall.

Building to Another Bubble?

In San Francisco the median home price recently topped 1 million. There are other signs that the market is heating rapidly. Banks are under more scrutiny and likely will not make as many questionable loans. On the other hand, very little regulatory reform has been enacted to keep a bubble in check. If the economy enters a strong growth phase, it is possible another housing bubble will form.