Housing bubbles can vary in terms of how long they last and how severe the impacts are when a bubble eventually bursts. But in a nutshell, housing bubbles tend to do more harm than good on an economic level, at least in the short term. The silver lining is that housing bubbles tend to be temporary events, meaning the housing market and the economy are eventually able to recover.
How Housing Bubbles Work
The term “bubble” is not unique to real estate nor is it a new concept. In fact, one of the earliest bubbles occurred in Holland in the 17th century, as trade in the tulip markets exploded, then collapsed, erasing fortunes rapidly. Housing bubbles have occurred several times in U.S. history, though the most memorable bubble is arguably the one that reached its peak in 2006-2007. In that instance, the bubble was largely driven by the expansion of subprime mortgage lending. In other words, too many borrowers were allowed to take out mortgage loans they couldn’t afford. As more people bought homes that increased demand, which led to more speculation. Meanwhile, the Fed was raising rates between 2004 and 2006 to help curb inflation. Subprime borrowers who had taken out adjustable-rate mortgages could no longer afford their monthly payments. Delinquencies lead to foreclosures, which lead to declining home prices, all of which caused the housing bubble to burst and the housing market to crash. The housing market crash had widespread impacts on the economy as a whole, triggering a recession. Some of the worst impacts included:
8.7 million jobs lost8 million homes lost to foreclosureLoss of equity for 95 million homeowners500 closings of community banks
The act was designed to address issues in mortgage lending that made it possible for the housing bubble and collapse to occur. The act also resulted in the creation of the CFPB.
The Housing Bubble vs. the Tech Bubble
The housing bubble was characterized largely by a push in subprime lending, which was fueled by speculative trading among hedge funds and other financial institutions. The Great Recession that followed saw net worth for American households shrink, home equity disappear, and unemployment rates skyrocket to 10.6%. As more people were put out of work, consumers cut back on spending and the economy continued to shrink. It took several government stimulus measures, including the Economic Stimulus Act of 2008 and the American Reinvestment and Recovery Act of 2009, to help get the economy growing again. Compared to the dotcom bubble, the housing bubble that happened in the mid-2000s was much more severe when measured by its outcomes. The bubble eventually burst as investors realized valuation estimates were way off the mark, causing a flurry of panic selling. But in terms of losses, they were limited to those who had invested in the bubble. Housing bubble losses, on the other hand, were spread out among a wider swath of Americans, including those with higher and lower household incomes. As spending among those with lower incomes slowed down, the economy itself slowed down, leading to a recession.
What It Means for Individual Investors
Generally speaking, real estate and stocks have a low correlation. So what happens with the housing market doesn’t necessarily affect what happens with the stock market or vice versa. That aside, it’s important to understand how a housing bubble could affect your portfolio both in the short and long term. If you’re a day trader, for instance, the impacts could be minimal if the causes of a housing bubble are not directly related to the stock market and the fallout doesn’t spur a larger recession. But if you’re concerned about a bubble preceding a recession, you may consider adding defensive stocks to your portfolio to help manage risk. For long-term investors, a housing bubble can be a reminder to review your current buy and hold strategy. If you own rental property, for instance, consider how a bubble may affect your ability to maintain tenants and collect rents. You may also think about selling if you feel a bubble brewing, but consider the bigger picture. If you can still afford to make the mortgage payments on the rental and your primary home, then you may be better off waiting for the home’s value and rent prices to eventually rebound. That also applies to non-property investments you own. For example, if you primarily invest in mutual funds or exchange-traded funds, you may want to review each fund’s underlying holdings to see how they may be affected in the event of a housing bubble. Rebalancing your portfolio can help with minimizing risk while also keeping you aligned with your investment goals. Consider talking to your financial advisor about the best ways to hedge against the impacts of a housing bubble or equity bubble collapse.
