What Is Froth?
Froth refers to market conditions preceding an actual market bubble, where asset prices become detached from their underlying intrinsic values as demand for those assets drives their prices to unsustainable levels.
Market froth marks the beginning of unsustainable rates of asset price inflation. An interesting example of a frothy market was Holland's tulip bulb market in the early 1600s. The market for tulip bulbs went through a huge run-up and crash.
People mortgaged whatever they could to raise cash to trade tulip bulbs. In 1633, a farmhouse changed hands for three tulip bulbs. The market top came in the winter of 1636-37 when a single tulip bulb, left along with 70 other tulip bulbs as seven orphans' only inheritance, sold for 5,200 guilders. Soon after the top, tulip bulbs traded for 1% of what they had two weeks earlier.
How to Spot Froth in Real Estate Markets
Sketchy loans are common. As evidenced by the 2008 recession, subprime lending is not sound practice in a healthy economy. Yet the U.S. government still backs loans that some might consider risky, particularly ones from the Federal Housing Administration Administration (FHA) that require only a 3.5% down payment. However, the underwriting standards are higher for FHA loans than with many of the subprime, low-down-payment products offered in the early 2000s.
There's lots of leverage at work. When someone takes out a mortgage, they're leveraging their money, and the smaller the downpayment, the more you have leveraged the deal by using the lender’s money.
Salaries aren't keeping pace with home prices. When housing prices are rising and salaries aren't, this is a good indicator of froth. If someone thinks their local market fits this description, it might be best to wait on buying a house, especially if you’re really stretching to make ends meet. As long as credit conditions from bank lenders are tight, runaway price inflation shouldn't happen, and you shouldn't have to pay much more if you wait – or buy in the suburbs.
Interest rates rise. Froth might be happening if, as soon as interest rates rise, demand for housing can fall. For instance, if interest rates increase by 1%, all the houses suddenly become unaffordable, and you’ll likely see a sinking housing market.
When there are no signs. High prices alone are not an indicator of froth. Rather, froth is indicative of unsustainable rapid price appreciation. A market is unsustainable if fundamentals do not support the appreciation. However, it is difficult to spot this kind of froth as it's happening; there may not be any obvious signs.