Asset Bubbles: An Application to Residential Real Estate

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.

Keywords: bubbles, residential real estate, limits to arbitrage, financial crisis

JEL Classification: G00, G01, G02, G10, R31