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Asset Bubbles: an Application to Residential Real Estate

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  • We are grateful to the referee, Malcolm Baker, the editor, John Doukas, Jorge Roldos, and seminar participants at Columbia University for their very helpful comments and suggestions, which, we believe, substantially improved this article. The views expressed in this paper are those of the authors and not necessarily those of the Board of Governors, other members of its staff, or the Federal Reserve System. This article was partly completed while Scherbina was visiting the IMF Institute, whose hospitality is greatly appreciated.

Abstract 

Behavioural models offer new insights into why bubbles are ubiquitous in residential real estate markets. These markets are dominated by unsophisticated households who often develop optimistic views by extrapolating from past returns. Rational investors cannot easily trade against an overvaluation of housing assets because of high transaction costs and a binding short sale constraint. Circumventing the effect of the latter, the supply of housing frequently increases in response to rising prices. This helps to mitigate bubbles but often leads to overbuilding, which slows down the recovery after a bubble bursts. Models that incorporate the effects of perverse incentives and limits to arbitrage are especially helpful in explaining the bubble that developed in mortgage-backed securities and helped fuel the recent real estate bubble by relaxing home buyers’ borrowing constraints. The literature is ambiguous about whether governments should intervene to burst bubbles, as a better response may lie in improving incentives of key market players.

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