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Housing Bubble - How to Identify One

Published by Lawrence Roberts | December 26th 2008 | Views:

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Prices went up a large amount during the Great Housing Bubble, but what makes this price increase a bubble? To answer this question it is necessary to accurately measure price levels and review historic measures of affordability to establish these price levels are not sustainable. Measuring house prices is not a simple task, and there are many methods market watchers use to evaluate market prices. These include the median, the average cost per square foot, and the S&P/Case-Shiller indices. Price levels in financial markets represent the collective result of individual actions.

There are techniques to measure the actions of the individual market participants and their impact on house prices. These measures are debt-to-income ratios and price-to-income ratios. The amount of debt people are willing to take on compared to the income they have available is their debt-to-income ratio. The amount of money people are able to put toward the purchase of residential real estate compared to their income is their price-to-income ratio. These ratios are important because they show how much people are borrowing and spending from their earnings to acquire real estate. When these ratios break with historic patterns, they signify a housing bubble.

There is a point where people are not able to bid up prices any higher because they do not have the savings or the borrowing power to pay more. This affordability limit determines where bubble rallies end; however, this limit is not predetermined or in a fixed location. The purpose of exotic financing programs is to expand this limit and bring more customers to the market and generate fees for the lenders. Unfortunately, these products have continually proven to be unstable, and the high default rates and lender losses inevitably lead to a contraction of credit known as a credit crunch. Interest-only and negative amortization loans created the housing rally and their elimination due to borrower default created the housing crash. The housing bubble was a credit bubble.
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