The Dynamics of a Housing Bubble

The 2008 financial crisis was spawned by an entire universe of shaky investments that involved the packaging of mortgages into securities. It turned out that many of these mortgages had virtually no chance of ever being repaid. When higher interest rates kicked in on these bad loans, the borrowers ended up defaulting en masse.

Much of this was related to an overarching characteristic of the pre-crash economy: there was a massive housing bubble. A housing bubble occurs when average home prices reach a level that is far higher than historic norms, based on things like the Consumer Price Index (CPI). In the case of the 2008 crash, the homes had reached all-time historic highs, with the average home across many communities being completely unaffordable to the average worker. Because so few people could afford these homes, many of the less solvent of them turned to the loose lending practices of companies like Countrywide. These were the mortgages that would go on to be repackaged into so-called collateralized debt obligations or CDOs. And it was these CDOs and the derivatives relating to them that nearly destroyed the entire Western economy.

Are we in a housing bubble today?

Over the last few years, the term housing bubble has been creeping back into the mainstream discourse. And to be sure, there are a few indicators that are pointing in the direction of a housing bubble forming today, especially in specific areas of the country.

What has caused today’s housing bubble?

Unfortunately, the conditions that caused the last housing bubble and subsequent financial disaster were never adequately addressed. One of the ways that the country was able to pull out of the recession that followed the 2008 market crash was a program known as quantitative easing and the Zero Interest Rate Policy (ZIRP). Combined, these two policies were enacted by the Federal Reserve to flood the markets with cash that would get the economy moving again.

However, all of that cash, easy credit and low-interest rates have conspired to run up housing prices to new all-time highs. Throughout much of the country, housing is once again completely unaffordable for the average worker. In Los Angeles, for example, the median wage earner would have to work nearly 120 hours per week just to afford the median home! And these sky-high prices are also driving up rents. Eventually, the fact that few people can afford the most basic apartment in major cities will force housing prices back to Earth, possibly sending them crashing.

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