Bubbles form in markets when there is such a large amount of demand that it drives prices up to levels where it is no longer supported by inherent value.
Bubbles have effects on an interconnected web of economic forces and institutions. It was postulated before 2008 that the housing market could not form a bubble in the same way the stock market could, but the subprime meltdown proved those theorists wrong. Bubbles are when a market suffers from unnatural price inflation due to speculation, bandwagon investing, and, to some extent, misinformation.
Bubbles burst when investors realize there isn’t much momentum left, or that there isn’t as much value as they thought underlying the investments. When the bubble bursts, like a thought-bubble in a cartoon daydream, there is a crash in which investors clamor to sell off their assets first, and a domino effect ripples through the businesses and portfolios that had strong positions in the asset.
In 2008 the bubble burst when the default rate on pools of mortgage debt reached a tipping point. Because too many subprime mortgages had been issued and their cash flows were sold off as higher-quality debt than they really were, many large institutions were caught off-guard when the effects rippled into their pool.
Billions of dollars of CMOs had become woven into the investment landscape, and the shockwaves were felt throughout the world. On Main Street, the everyday people with mortgages now discovered that the value of all the homes in their neighborhood had suddenly plummeted, and that they owed significantly more principal on their mortgage than their home was then found to be worth.
Federal programs such as Fannie Mae and Freddie Mac had made it easier for banks to make mortgage loans, but they also transferred a lot of the risk away from the lending institution, accidentally encouraging too many bad loans.