ISSUE: Economic bubble and its application to real estate market.

ECONOMIC BUBBLE: “Bubble” is defined as the growth rate that occurs faster than an exponential growth. This definition is the econometric definition and the requirement is more stringent than a common understanding of ‘sustained and fast growth.”

The common method used to study economic bubble is the Johansen-Ledoit-Sornette (JLS) model. The model is based on rational expectation with finite-time singular crash hazard rate. Bubble is created by behaviors of investors/buyers producing positive feedback in the valuation f asset leading to the understanding of growth ending with a finite time at a future time. Under this definition, “bubble” is a misunderstanding of buyers that there is a growth. As soon as this misunderstanding is discovered, the feedback mechanism would cease. The cessation of feedback mechanism often spells the “crash” at a finite-time call tc.

The JLS starts with rational expectation with the following definitions: Po = observed price, P* = fundamental value, and P = bubble component price; thus:

(1)   P0 = P* + P

Argument (1) satisfies a stochastic differential equation with draft:

(2)   dp/p = mu(t)dt + sig(dW) – kdj

… where p = bubble price; mu(t) drift or trend; dW = increment of the Wiener process with zero mean and unit variance; dj = discontinuous jump such that j = 0 before crash and j = 1 after crash; and k = loss amplitude due to crash.

The dynamic of the jump in JLS model is determined by the hazard rate. Recall that the general statement for hazard rate is represented by h(t). Between time t and t+dt, the probability of the crash hazard is given by h(t)dt. Thus, the expected jump is given by:

(3)   Et[dj] = 1 x h(t)dt + 0 x (1 – d(t)dt)

The expectation of dj is follows:

(4)   Et[dj] = h(t)dt

If buyers buy in a frenzy just because everyone else is buying and selling, this behavior is called “herding” behavior. In this scenario, the crash or hazard rate will occur at:

(5)   H(t) = B’(tc – t)m-1 + C’(tc – t)m-1cos(w ln(tc – t) – F’)

In a non-arbitrage condition, the expected Et[dp] of the price increment is zero resulting in:

(6)   Mu(t) = E[(dp/dt) / p]

Recall the positive feedback mentioned above. The feedback comes from two mechanism: (i) technical class of buyers, and (ii) herding or imitators. Technical class buyers/investors engage in trading by technical analysis. Imitators act by following the crowd. The effects of these two types of feedback create price movement in a form of log-periodic according to log-periodic power law (LPPL). LPPL may be given as:

(7) Ln E[p(t)] = A + B(tc - t)m + C(tc - t)m cos(w ln (tc - t)) - F

… where B = -kB’/m and C = kC’ / sqrt(m2 + w2); and m = measure of exponential price growth. The value of m is between 0 and 1.

The estimated crash time for the bubble is:

(8)   tcestimate = tctrue + e

… where tc(est.) is non-random and unknown.

RESIDENTIAL REAL ESTATE BUBBLE: Real estate bubble may not qualify for the definition in JLS. A lesser growth rate may be defined. A lesser degree of “bubbling effect” in real estate may be degenerated to “hyperinflation” of property price. Therefore, the term “bubble” used in real estate market is less restrictive than what is required by econometric model.

EFFECT OF BUBBLE: If bubble results from economic overheating, it is likely that the state will respond at a macro-level to slow down the inflationary pressure by raising interest rate. Raising interest rate may send a shock into the system to burst the bubble. The state would probably achieve its over all goal of slowing down the overheated economy, but in the real estate sector the shock could be devastating since real estate purchase in developed economies is financed by bank loan. Larger price tag on real estate purchase means larger loan. Larger loan means larger mortgage burden. When the economy slows down, certain percentages of mortgage tend to go into default---hence bubble burst.

   Economic bubble in the real estate market may further enlarge the gulf between the rich and the poor. Only the rich would be able to afford real property purchase when the price spins out of control. The working class would be left out of the market. In the long run, this development tends to brew social discontent.

PREVENTION: Bubble occurs as the result of sustained economic growth to the point of “over-heating” combined with shortage of supply (in case of real estate). It is not easy to prevent economic bubble in real estate unless the state regulates price movement in land sales. However, price regulation is not easy if the supply of land is limited. For example, Hong Kong and Singapore have limited residential land. The land size does not growth, but the population grows every year. In such a scenario, price anomaly is almost inevitable. “Population control” is not an option in this case because on the balance when we weigh fundamental freedom against economic convenience, the liberty of citizens would always take precedence.

If real estate purchase is accomplished through bank financing, bubble be prevented through loan regulation, i.e. requiring banks to require larger down payments or the central bank may increase interest rate. Real estate bubble is a symptom from macroeconomic fundamentals. The economy as a whole may be overheating, i.e. faster and larger growth or inflationary pressure. Raising interest rate to slow down the economy may help ease the bubble effect.

    Methodologically, bubble is not possible to forecast. However, when the bubble occurs (hence post facto), there are models to prevent its cash (tc = time critical).

REFERENCE:

Sornette, J.D.A. (1999). Critical crashes. Risk 12(1); pp. 91-94.

Sornette J.D.A. and Ledot, O. (1999). Predicting financial crashes using discrete scale invariance. Journal of Risk. 1(4); pp. 5-32.

Sornette J.D.A. and Ledot, O. (2000). Crashes as critical points. International Journal of theoretical and Applied Finance 3; pp. 219-255.

A bubble is financial terms implies an increase in the value of a real or financial asset not back by a fundamental increase in its value. Bubbles can be as a result of a demand/supply dis-equilibruim, and excessive speculation. With a globalized financial environment and global increase in investment, the property market comes in handy to both foreign and local investors seeking higher returns, causing a phenomena increase in property value(The Bubble). If the effective demand for property whether residential or non- residential is lower than supply, the price will fall leading to a burst or a rapid deflation of the bubble. To prevent a bubble, asset prices need to be properly valued and revalued periodically, and adjusted as such. Thank You.

The real estate bubble or housing bubble occurs when real estate prices increase steadily due to increased demand and speculations.

The real estate bubble usually starts when property demand increases, if the offer is limited when demand increases, it usually takes some time for the offer to meet this demand.

Then speculators enter and speculations begin in the real estate market at this time, increasing the demand for a larger proportion.

The situation in the market is now that demand and supply are increasing, this may sound good, but at some point demand is lower or stabilized while supply continues to increase continuously, causing a sudden and sharp decline in prices and a bursting real estate bubble.

According to its definition, the real estate bubble always explodes, if it does not explode it has never been a bubble!

 Bubbles always explode, hence the name!

Unfortunately, the discovery of a real estate bubble is often a difficult challenge until the bubble bursts. This is always the moment when the increasing supply of real estate in the market collides with a halt or lack of demand.

Sometimes prices reach a stage where people can not buy then demand stops, prices fall suddenly and the bubble bursts!