Housing Bubble

Introduction

A rapid rise in housing prices followed by a subsequent abrupt decline is generically referred to as a housing bubble. While the term bubble frequently appears in both the popular press and academic literature, it doesn't have a precise definition. Here people refer to a bubble as a price increase unrelated to fundamental factors, but related to past price increases. In other words, a bubble is unjustified price momentum. This definition is consistent with Stiglitz (1990). Housing prices began to rise rapidly in 1997 and fell suddenly in 2007. The sudden decline in housing prices and increase in foreclosures had a severe contagion effect in the mortgage backed security and credit default swap markets. Arguably, the housing price decline is what started the recent financial crisis. Much of the discussion of the financial crisis centers on sub-prime lending. The advent of sub-prime loans and the increased use of zero equity loans, certainly increased the likelihood of loan defaults and therefore increased the likelihood of the housing price decline in 2007. Therefore, all the issues related to Housing Bubble will be discussed in detail.

Discussion

Many people theorize that housing prices are a reflection of several fundamental macroeconomic inputs. We incorporate real income, a risk premium, mortgage rates and past prices into a vector error correction model to analyze the interaction of these variables. The economists use real Gross Domestic Product (GDP) as a proxy for income, the default premium as a proxy for risk, the historical 30-year conventional mortgage interest rates as a measure of the interest rate environment and a real home price index as a proxy for housing prices. For most individuals, the purchase of a house represents a substantial portion of their income. As a normal good, housing demand should be positively related to income. At the aggregate level national income will be positively related to Gross Domestic Product (GDP). GDP provides a measure of the overall economic output of the economy. As a measure of the market value of all goods and services produced or delivered within the borders of the U.S., it is often used as a proxy for standard of living. While using GDP as an indicator of standard of living has some disadvantages -namely GDP does not take into account things such as unpaid work (e.g., household work), distribution of wealth, changes in quality of life and changes in quality of goods - its use as a common proxy for standard of living has some advantages because of the frequency and availability of the data. Real GDP provides an indicator of the health of the U.S. economy as well as an indirect barometer of consumer attitudes, and thus if real GDP is increasing, people should expect to see an increased demand for housing (Anas, 1464).

Even with a constant expectation of future cash-flows, asset prices can change if discount rates change. Discount rates are a combination of the time preference and an adjustment for risk aversion. An apparent anomalous run-up in asset prices ...