Behaviors that Lead to Real Estate Bubbles

The real estate and subprime mortgage bubbles that burst and cascaded through the global financial system leading to the Great Recession offer an opportunity to examine why such bubbles form and how to minimize their impact. Assistant Professor Anna Scherbina and co-author Bernd Schlusche from the U.S. Federal Reserve Board are using behavioral models to study the dynamics of residential real estate bubbles.

In their paper, “Asset Bubbles: An Application to Residential Real Estate,” forthcoming in European Financial Management, Scherbina and Schlusche highlight incentive problems of key market players and discuss why real estate bubbles can cause greater adverse impacts on the economy than equity bubbles. “A typical household has more exposure to real estate than to the stock market,” Scherbina said. “Through its effect on households’ balance sheets, real estate price fluctuations can have a strong feedback effect on the real economy.”

The paper divides these behavioral models into four classes. First, buyers disagree about the fair values in the market, and investors who believe prices are unrealistically high cannot sell short, like they could with stocks, which would correct the market. Second, investors assume the most recent price trends will continue, which ensures that indeed they do. Third, investors pay attention only to public signals that confirm their prior ideas but ignore signals that do not. Fourth, investors put their faith in attention-grabbing news and then are slow to change their minds when confronted with new facts.

To prevent future bubbles, Scherbina offers three suggestions: make short sales possible with real estate the same way they are with stocks; regulators can ensure that the incentives of financial intermediaries are not compatible with churning bubbles and that the incentives of information intermediaries are better aligned with telling the truth; and governments can provide better financial education to reduce the adverse effects of investor irrationality.