To understand when and if the housing bubble will pop or deflate, one point of view is to look at how investors and your everyday John Doe can continue to purchase property even as prices skyrocket.  Either their income have significantly risen or mortgage companies and banks have made it easier to borrow money.  When these factors supporting continued purchases of existing and new homes dissipate, the bubble will begin to deflat.

Many articles have shown that income have not kept up with the rising housing prices in major metropolitan areas.  Still mortgage rates have been kept relatively low in the 6′s for 30 year fixed rates.  Despite Fed hiking the rate at every meeting, long term rates have not risen accordingly.  This is because overseas investors continue to puchase the mortgage backed securities (MBS) that come from the mortgage.  To understand this, we need to understand how banks can lend money continually (they don’t have unlimited supply of cash!!)  After banks make a loan, banks can either hold on to the loan on their books, or they can sell the loan to Wall Street.  When banks sell the loans, their cash is replenished and this process allows banks to make more loans.  Wall Street accumulates the loans bought from mortage companies, local banks and when they have a substantial amount, usually in the hundreds of millions, they “securitize” the loans into a mortgage backed security.  This is a bond that derives its cashflow from underlying mortgage payments.  This bond is then sold to investors.  Overseas investors in countries like China have been big purchasers of these MBS.

To best understand this, we can look at how cash changes hands.  First, Chinese investors purchases the MBS from Wall Street.  Every month, John Doe makes his mortgage payment.  That mortgage payment is passed onto the Chinese investor.  Investors essentially provide liquidity for the massive amounts of loans that have been generated in the last few years.  But that may or may not continue indefinitely.  Booming markets such as India (have you seen their Equity index in the last 3 years?? It’s ben a very wild ride) are attracting lots of foreign investors.

If there are not enough investors of the US MBS, then banks necessarily have to raise the rates to justify making the loan to be held in their books instead of selling the loan to investors.  When banks start to raise rates to 7, 8 or 9 percent, everyday John Doe won’t be able to afford that loan and the support for housing prices will weaken. 

This is not a doomsday scenario.  But just one likely and possible outcome.