Financial bubbles have fascinated economists for hundreds of years. One of the earliest and best documented occurred in the early 1600s in Holland, where investors became obsessed with buying and selling tulip bulbs -- the rarest and most beautiful tulips sold, for the equivalent today of thousands of dollars each.
A brilliant financier named John Law, who induced huge investments in Mississippi land, engineered another bubble in France in the early 1700s. It eventually came crashing down in one of the most spectacular market collapses in history, wiping out the wealth and savings of thousands of Frenchmen.
At about the same time, something similar was going on in Britain involving the South Sea Company, which held a monopoly on Britain's trade with the Americas and also owned a big chunk of its national debt.
Since then, there have been many other cases where bubbles have emerged, and economists continue to study them. Most recently, millions of Americans had direct experience with the huge run-up in the stock market in the late 1990s and subsequent crash in the 2000s. At one point, people took seriously books predicting that the Dow Jones Industrial Average would reach 36,000 or even 100,000. Today, the Dow is exactly the same as it was when those books were published six years ago -- around 10,500.
Of course, the authors never said when the Dow would hit those numbers. Undoubtedly, they will be proven right someday in the far distant future. But as a guide to one's current investment strategy, they weren't very helpful. In retrospect, the presence of such books on the best-seller list was an almost sure sign that the market had peaked and it was time to get out.
Today, many of the same economists who correctly predicted the bursting of the stock market bubble, such as Yale University's Robert Shiller, are saying that the housing market is in a bubble. If it should collapse as the stock market did, the impact could be even more painful. Consider this evidence.
-- Homeowners are much more leveraged than they used to be. According to the Federal Reserve, Americans' home equity has fallen to 56.3 percent of their real estate, from 75 percent a generation ago. Another Federal Reserve study found that 16 percent of the money taken out was simply consumed.
-- According to Freddie Mac, people are taking more and more money out of their homes. Cash-out refinancings have risen to 18.1 percent of all refinancings, from 7.2 percent in 2003. In the last four years, homeowners have taken $559 billion in equity out of their homes.
-- More and more homeowners are buying and refinancing with unconventional loans, such as adjustable-rate and interest-only mortgages, rather than traditional fixed mortgages. Such loans have lower initial payments, but will rise automatically when interest rates rise. The Federal Reserve says that 47 percent of all residential mortgages by dollar volume are now non-traditional.
-- A new study by National City Bank found 53 cities in which home prices were in bubble territory -- defined as 30 percent above where they should be based on local income growth, population density and other factors. Santa Barbara, Calif., ranked as the city with the most overpriced real estate -- 69 percent above fundamental value. Based on the ratio of rent to home prices, prices nationally are now almost 40 percent above where they should be.
-- A new study by the Public Policy Institute of California found growing numbers of homeowners paying as much as 50 percent of their income for housing, including mortgage, taxes, insurance and utilities. In California, 15.4 percent of homeowners fall into this category -- including 20 percent of recent homebuyers -- and 10.6 percent nationally. Almost 40 percent of Californians pay at least 30 percent of their income for housing, with 29 percent doing so nationally. According to Fannie Mae, 28 percent is the most one ought to pay.
According to the National Association of Realtors, 23 percent of homes last year were sold as investments, and another 13 percent were vacation homes. With rapid appreciation being a prime motive for both, any falloff in housing prices could cause many of these properties to be dumped on the market quickly, potentially turning a housing downturn into a crash.
This does not exhaust the signs of a housing bubble. Those with an interest can find growing numbers of websites devoted to the topic. Among them are http://bubblemeter.blogspot.com, http://thehousingbubble2.blogspot.com and http://www.housebubble.com.
Economist John Makin of the American Enterprise Institute notes that housing has a powerful effect on economic growth through construction, employment, purchases of durable goods like refrigerators and other ways. He estimates that if home prices simply level off and stop rising, it will cut 1 percent off the real gross domestic product growth rate.