Asset bubbles happen when the price of assets, such as homes, stocks, or ​gold, skyrockets quickly. People will buy the asset because prices are rising, and they want to get in before prices increase even more. They will often bid the price up beyond its actual underlying value.
Eventually, the bubble bursts. The price becomes just too high, and demand drops off. Often, some other intervening event occurs, and people panic. It's good for you to understand the causes and past bubble so you can avoid the next one.
Causes of an Asset Bubble
There are three main causes of an asset bubble.
- Low interest rates: Low interest rates make it easy to borrow money cheaply, which boosts investment spending. However, investors cannot receive a good return on their investments at these rates, so they move their money into higher-yield, higher-risk asset classes, spiking asset prices. (Source: Board of Governors of the Federal Reserve System. "How Should We Respond to Asset Price Bubbles?")
- Demand-pull inflation: This occurs when buyers' demand for an asset exceeds the available supply. The sellers of the asset then raise the prices.
- Asset shortage: This occurs when investors think that there is not enough of a given asset to go around. Such shortages make asset bubbles more likely, because the imbalance between supply and demand leads prices to rise beyond the asset's value.(Source: The Brookings Institution. "The Origins of the Financial Crisis," Pages 8, 26–32.)
2005 Real Estate Asset Bubble
The 2005 real estate bubble was fueled by credit default swaps. These insurance policies protected investors against defaults of derivatives such as mortgage-backed securities. It allows one lender to "swap" its risk with another. Like an insurance policy, the buyer makes periodic payments to the seller. The seller of the swap promises to cover the investment if the mortgage holder defaults.
In the early 2000s, hedge fund managers created a huge demand for these supposedly risk-free securities. That, in turn, boosted demand for the mortgages that backed them. To meet this demand for mortgages, banks and mortgage brokers offered home loans to just about anyone. That drove up demand for housing and increased home prices, creating a housing bubble.
When the homebuilders finally caught up with demand, housing prices began falling in 2006.5 That burst the asset bubble and caused the subprime mortgage crisis in 2007 and the 2008 recession.
