When the world seems “broken” the incentives are wrong.

Pretty much every time I notice something in the world that seems "broken" the analysis eventually leads me to think that the incentives are structured in a way that causes the brokenness.  Take the recent mortgage crisis, and look at what was driving the behavior of the key stakeholders:

Real Estate Agents:  Both buyers and sellers agents are paid a percentage commission on the sale price.  This means that the "knowledgeable representatives" on both sides have a financial incentive to get houses to sell at the highest price possible.

Mortgage Brokers:  Again, usually paid either a flat commission, or a percentage commission.  Either way, they earn exactly zero dollars for the mortgage they say shouldn’t happen.

Mortgage Lenders: This group was a major part of the real problem.  Mortgage lenders, through bundling and selling of mortgage backed securities, had no incentive to turn away bad loans.  The mortgage backed securities were selling at a value that didn’t account for the risk using standard economic formulas, so the lenders had an incentive to accept risky loans and sell them, passing the risk along to people who had no ability to understand the risk they were accepting. Basically the more they could get a potential homebuyer to promise to pay, the more money they made.  No incentives to push down the price of homes.

Appraisers: This is the group that should have been the safety net, but it seems that they’ve turned into yes-men (and women) for the Real Estate Agents and the Mortgage Lenders.  They are well insulated from liability by the formulas they use, and are dependent on Agents and Lenders for referrals so that they can make a living, so they have no incentive to challenge the value of an overpriced home.

Home Buyers: This group seemed, as a whole, to believe that as long as they planned to sell their house every few years, they should buy as much house as they could afford in order to maximize the future profit.  As a whole it looks like we bought into all of the advertising that claimed that houses were a great investment, touting huge yearly percentage gains in value, even though the fine print read "past returns are not a guarantee of future performance."  Greed, and the blind hope for turning a profit led this group to accept the inflated values as a reason to buy.

Home Sellers: Finally we get to the one group that should have been putting upward pressure on home values.

So, we now have a correction of sorts underway.  Home buyers are wary of getting into the market for fear that the values will continue to drop.  Mortgage brokers and lenders know they can’t bundle and sell risky mortgages since there will be too much scrutiny, but they do seem to be trying to lock in anyone that has a good to excellent credit rating.  I haven’t seen any real changes in the real estate market, but I’d be amazed if there isn’t at least some fear of liability if an agent helps someone buy an overvalued home.

The current climate of fear and risk aversion has slowed the bad behavior, but nobody seems to be talking about fixing the system.  If we come out of this and the incentives haven’t changed, then the bubble will just grow, and pop, again.

One Man’s Over-Simplified View of the Stock Market

It’s a bit troubling to watch investments freefall like they did last week.  It seems like everyone is expecting the government to be able to pull some sort of brake to stop the freefall, but in actuality there’s very little that the government can do that will have an immediate effect on the stock market. 

In my mind, I have over-simplified the pricing of stocks to this:

[Stock Price] = α[intrinsic value] x ß[extrinsic value multiplier]

Every stock valuation equation that I’ve ever seen ends up being some derivative of the above, where the intrinsic value is pretty constant and is related to the company’s holdings and it’s ability to generate consistent profits. The extrinsic value is subjective and can vary widely and can be seen more as a measure of the confidence that the pubic has in a company.

Over the last few weeks, the real inherent value of the companies that make of the DJIA, the S&P, and the market as a whole has not really changed.  What has changed it the perception of the extrinsic value, i.e. the potential for continued growth in value and earnings, and the ability of the company to weather a slump in the economy.

Now the interesting dilemma facing those in power right now is that everyone is screaming that they need to fix ß when the only way to fix ß is to set up a system that protects α, and that gives confidence to the public that you will continue to support α in the future.

As much as I am instinctively against the idea of the current bailout bill, there are some facets of it that make sense, and I think we’ll start seeing some progress in the next few weeks.  The bailout bills’ main focus is to break-up the gridlock that we currently have in the short-term liquidity markets.  This protects α by helping companies that have real value to avoid folding simply because they can’t get the short-term loans they need in order to operate. This helps us avoid a real reduction in the intrinsic value of companies, and in the long run that should be the focus of every leader who is currently attempting to help solve this crisis.

Disclaimer:  This post is not financial advice, I may have a business degree but I don’t claim to have any special expertise in economics.  I just had a few ideas I wanted to spout off.