Two years ago, your co-worker bought a house in your neighborhood at a steal price. This year, you decided to jump into the house-hunting game … and discovered that a similar house would cost 20% more.
Yikes! With property values rising so quickly in many parts of the nation, are we on the verge of another housing bubble?
In one word: no. In fact, we are far, far away from bubble territory. Below, Trulia shares a few housing bubble basics showing why we’re a long shot from the next housing bubble.
What’s a bubble?
Let’s start this explanation with the basics: What’s a housing bubble?
A “bubble” is an unsustainable rise in prices, often fueled by speculation and lending. It’s characterized by easy credit, irrational exuberance, and a rapid rise in prices.
Bubbles can affect housing, commodities such as gold or copper, or the overall stock market as a whole.
What caused the last bubble?
Several factors contributed to the last housing bubble, including:
1. Loose lending standards
During the last bubble, financial institutions lent money to anyone with a pulse. (That’s only a half-joke.) The criteria, or standard, that borrowers needed to meet to qualify for a loan were a very low bar.
For example: Many institutions didn’t require borrowers to prove their income. The borrower would self-report their income (write down a number), and the lender did nothing to independently verify whether this number was accurate.
What happened? People borrowed more than they should have — often on adjustable-rate mortgages, which had low introductory teaser payments followed by higher payments several years down the road. Eventually, they couldn’t make their payments, which led to foreclosure. Ultimately, when this happens to a large population of homeowners, it depresses housing prices.
Many people assumed that houses will always rise in value. As a result, a rush of builders and developers hurried to create new construction, glutting the market with inventory.
How did the developers pay for this construction? With loans, of course.
Banks issued loans to builders, who created massive inventory, and also issued loans to individual buyers, who gobbled up that inventory.
As a result, builders began overleveraging. Developers would borrow massive amounts of money to build homes “on spec,” on the assumption that demand would never cease.
And for a while, they were right. Buyers, who assumed house prices would rise forever, and who easily qualified for mortgages, eagerly bought houses. This fueled builders’ enthusiasm. And the self-reinforcing cycle continued — all built on a foundation of easy credit and an assumption that prices would keep rising.
3. CDO sales
Here’s a third reason a bubble formed: The banks needed money to issue loans. Where would that money come from?
From securities. Functionally, the banks borrowed money (by selling “collateralized debt obligations,” or CDOs) and used that money to issue loans to builders and buyers. The banks earned profits on the “spread” between the rate at which they could borrow and the rate at which they could lend.
And that’s fine — as long as the banks are borrowing at an interest rate that’s aligned with the actual risk involved.
Here’s where trouble entered the picture:
Banks took the riskiest loans (subprime loans) and packaged them as ultrasafe securities (CDOs). In other words, they sold risky assets under the guise of safe assets.
And they did this a LOT. In the three-year timespan from 2003 to 2006, CDO sales rose tenfold, going from a $30 billion industry to a $225 billion industry.
When housing prices dropped, many investors (including many major institutional investors, such as the government of Iceland) lost their investments in these securities. This triggered capital markets to plummet.
Why it’s different today
The three conditions outlined above are drastically different today:
1. Stricter lending standards
Today’s borrowers must meet higher standards. They need strong credit scores, low debt-to-income ratios, and (generally) need to provide at least two years of proven income history. Financial institutions will look at their pay stubs and tax records to verify their income.
The result? Today’s borrowers are more likely to be able to actually afford their loan repayments — meaning fewer of them will be subject to short sales and foreclosures.
2. Less speculation
Banks have much stricter lending criteria for both builders and buyers. Investors can no longer create a real estate development company on leverage alone; they often need a hefty down payment (25% to 30% or more) to borrow the funds to build a new condominium complex or apartment building. The “loan-to-value” ratio, as it’s called, is stricter than ever.
3. No CDO bubble
As you might imagine, institutional investors are now leery of complex financial instruments such as CDOs. The explosion of CDOs from 2003 to 2006 isn’t repeating itself today.
So why are housing prices skyrocketing?
Many people look at one characteristic of the 2014 housing market — the rapid rise in home prices — and wonder if we’re in another bubble.
We’re not. The main drivers of a bubble (easy credit, loose lending standards, and overblown enthusiasm and speculation) aren’t present in today’s market.
In many major markets across the U.S., year-over-year housing prices appear to have made enormous gains. According to Trulia’s Bubble Watch Report, year-over-year growth in asking home prices (as of February 2014) is up 12.6% in Atlanta, 10.4% in Indianapolis, and 15.8% in Dallas. In other words: Cities across the nation are seeing impressive gains.
But those gains are a drop in the bucket compared with how much further they need to recover just to reach “normal” levels.
The peak housing prices, by the way, aren’t considered “normal.” During the bubble, houses were overvalued by anywhere from 8% in Houston to 86% in Miami. When the bubble popped, houses plummeted into “undervalued” territory.
And while those values are recovering, many cities across the U.S. still feature undervalued houses.
Houses in Atlanta, for example, are still undervalued by about 15% — in spite of the 12% year-over-year price surge. Indianapolis homes are undervalued by 13%, while Dallas homes appear to be at “normal” levels — neither under- nor overvalued.
Some cities (especially in California) are seeing house prices that appear to be slightly overvalued. But today’s overvaluation pales in comparison with the wild speculation that fueled the bubble from 2002 to 2007.
So if you want to buy a home, don’t sweat that it looks as if we’re in a bubble. Today’s market is different from the one we experienced a decade ago.