Following EU accession Estonia experienced a loan financed boom. The boom was characterised by overinvestment in the real estate and construction sectors fuelled by strong growth in housing loans, particularly those with variable interest and denominated in foreign currency. Now these sectors are facing a downturn, which has already affected overall economic activity. Since the two sectors are closely linked, problems in one may spill over to the other. So far, risks have mostly spread from the housing market to the financial sector, as most of rapidly rising lending consisted of mortgages, which are now suffering from increasing defaults. At the same time, tighter lending conditions have dampened the demand for housing. More recently, global financial distress has led to a credit crunch and further exacerbated the downturn. At this juncture, co-operation is required between regional financial supervisory authorities to mitigate risks to financial stability as well as cyclical volatility in housing and construction. Looking ahead, financial stability could be strengthened by increasing households’ financial literacy, especially regarding the risks of high indebtedness and variable rate loans. The development of fixed rate loans could be encouraged through surveillance activity by the Bank of Estonia and/or the Financial Supervision Authority, to ensure that commercial banks are appropriately pricing credit risks. Moreover, the mortgage-based lending system accompanied by a securitization scheme should be adopted over the medium term. A careful redesign of fiscal incentives and other housing policies could bring about a better allocation of resources and increased labour mobility.