Friedrich von Hayek is rolling his eyes. The economist who inspired Reagan and Thatcher is probably wondering why we are messing around with the mortgage crisis in America when the market is correcting itself. The answer: people matter. Of course we risk a lot by helping our ourselves. Its a tough call but we always side with a known today (helping sub-prime borrowers) for an unknown future (moral hazard).

Of course John Maynard Keynes is loving this. Paulson managed a middle way by strong arming the industry into a voluntary solution.

This mortgage bailout, as narrow as it seems to be, has me thinking about free markets versus more interventionist Government approaches. This recent Paulson response, as weak as it is, still has me wondering what role governement should have in this. If the industry hadn’t done consumers wrong, I would be arguing that we should just be helping people adjust to becoming renters again. However, the mortgage industry is fundamentally responsible for most of this situation. They leveraged consumer ignorance - not the first industry to do so. Because of the false promises signaled by Government to look after consumers - think FDA, OSHA, Fed Reserve, etc - the Government should respond. Of course I always prefer a market response - which we are getting - but the damage is real and people will lose faith in what America stands for if we don’t correct the wrongs committed by the mortgage industry.

Nevertheless, I do worry that we are setting a bad precedent that may forever alter consumer and business expectations about government. Flash forward 20 years and I wonder if this situation we will have looking more socialist. There are plenty of precedents in other countries to suggest that Government hand-outs breed future generations of citizens with artificial entitlement expectations.

An example? Sure. In Egypt, baladi bread was heavily subsidized to the tune of 11.7% of total government expenditures by 1980. This subsidy started in the 1941 as a response to protests by citizens related to the fact the domestic bread prices were high and supply limited. Bread is responsible for 33% of caloric and 45% of protein intake and has a long dietary history in Egypt going back to the days of the Pharoh’s. Due to the 1941 protests, the government acted by subsidizing all parts of the bread making process and essentially making bread an entitlement. In 1977 the Egyptian government woke-up to the financial mess they had before them and tried to increase prices. The result was a massive riot that erupted in violence and deaths. The last time Egypt saw riots of this size was 25 years earlier when King Faouk was forced out of office and thrown into exile. To this day it is a massive political headache and financial drain for Egypt.

So well done Mr. Paulson but please, please, please go after the perpetrators of the mortgage mess because our faith in Capitalism hangs in the balance.

The National Association of Realtors reported that their “Pending Home Sales Index” for July fell to its lowest level since the post Sept. 11, 2001 period as a result of tightening credit for Jumbo mortgage loans (loans over $417,000).

So what is this index? Directly from the NAR release:

“The Pending Home Sales Index is based on a large national sample, typically representing about 20 percent of transactions for existing-home sales. In developing the model for the index, it was demonstrated that the level of monthly sales-contract activity from 2001 through 2004 parallels the level of closed existing-home sales in the following two months. “

It seems that Three Stooges of the mortgage ecosystem, lenders (Curly), Wall Street mortgage underwriters (Moe), and mortgage buyers (Larry) all woke up after a night of drinking and decided never again (well, at least for a few weeks!) ! These Jumbo loans are NOT purchased by the quasi-government agencies Fannie Mae or Freddie Mac whose job it is to purchase loans from lenders so that lenders have the funds to make more loans - a mechanism to facilitate home ownership for average and lower income home buyers. Jumbo loans do not qualify so they must be either held by lenders or sold to investors via wall street. Since Fannie and Freddie have continued to support loans at the low-end while the high-end has lost free market support, Jumbo’s have shut down for the minority and have gotten MUCH more expensive for the majority. Not surprisingly, the Western part of the US, which has the highest home prices and presumably the most Jumbo loans, got hit hardest being down a whopping 20.8% to 82.3 versus 89.9 nationally.

Will this last? No way. This is a temporary disruption as people reorient their perspective to risk. Will the cost of jumbo’s (as a spread to treasury securities) increase? You can bet on it!

Hi Everyone,

I want to apologize for the outage we had today. There is no excuse and I want you to know we will work to ensure that this doesn’t happen again. One of the challenges of being a start-up is not being able to do the things we know are necessary due to a shortage of time, people, and money. We take risks rather than play it safe and, unfortunately, we rolled a snake eyes.

A couple of things I read this weekend are reinforcing something that I have been thinking about the contrasts of old-school business models and (the promise) of new school businesses. I don’t want to quibble about who is “old” and who is “new” but I guess the test is this: “Do you make a truthful promise to your customer?” Take at a look at theses facts, as an example, below:

- 50% of sub-prime borrowers could have qualified for prime rates, according to Fannie Mae

- “Yield Service Premiums” (kickbacks from lenders to mortgage brokers) are present in 85-90% of sub-prime loans.

- US Dept of Housing and Development estimates that 1 in 9 middle income and 1 in 14 upper income families have sub-primes

Are you kidding? As my kids would say “Sheezamageezza!”

This is old school businesses doing its thing of false promises (of their product or service) and lies (not disclosing dangers or conflicts of interest). Someone posing as an “agent” to a mortgage consumer “advises” that a specific product is “best” and the naive consumer accepts this as fact. Even corroboration with another mortgage broker may not yield substantially better terms because, well, the incentives are the same. The “agent” can sell 6.5% loan and make $3,000 or the 9.5% loan and make $15,000. Easy choice for the “agent”.

The issue is this: consumers are directly or implicitly promised one thing and given another. Bait and switch. Unfortunately, false promises are devastating people everywhere - like in the in sub-prime loan sector. Sadly this isn’t new - this is how business has been done forever and this still happens everyday. Think about all those commercials for processed food claiming to be healthy. This cereal or that snack bar. What do you think when you see this?

The company’s website says “symbols of quality, great taste, and nutrition”. Yet if you look into the ingredients you will see:

Its all crap yet somehow people trust that Quaker is a trusted source of nutrition. The brand promise is improved health and the delivery is poor health. The mortgage broker category promise is best rates and the delivery is, for some, the worst rates. False promises and lies - everywhere.

The business people I meet everyday don’t conspire against consumers but rather are reacting to and responding to duplicitous commercial behavior. This is a market response that will win - eventually.

Interestingly there are others looking at this as well. One the one side are those, like Greg Swann in this wordy post, that believe that regulation should be replaced with personal responsibility and free market solutions as it relates to, for example, real estate agents.

On the other hand, there are those like Elizabeth Warren, a Professor of Law at Harvard Law School, that make an argument for more regulation in a post entitled “Unsafe at Any Rate” referencing the dangers of various consumer financial products and services.

Swann makes the argument that there should be no licensing requirements for real estate agents and that the industry is using regulations to benefit themselves rather than consumers. I agree that the there is a false promise made to consumers with the agent “licensing” scheme but am undecided if removing licensing makes sense for the very same reason that the sub-prime market is a mess - consumer ignorance and bad actors (although not necessarily illegal actors) yield substantial problems. Matters of health and safety are basically the governments job and so just where the lines of safety end is very debatable. Should financial safety be elevated to bodily safety?

Warren thinks so. Her argument is basically that consumers are subjected to too much complexity - complexity meant to trick consumers or keep them ignorant. For example, most people need not scrutinize consumer products at an engineering level because the government sets saftey guidelines and requires clear saftey disclosures. Yet for financial products it is essentially caveat emptor. Consumers must do the equivelant of engineering (and law) to understand the products they are buying and the risks that they are taking. Adding conflicts of interest, common in the mortgage brokerage and payday businesses, makes consumers that much more vulnerable.

The free market rebuttal to Warren is that a market solution will evetually emerge, which I agree with, but the issue really is how many people must suffer in the interim? How many false promises and lies must people endure before a market solution kicks in? What is an acceptable casualty rate?

Yesterday the NYT’s David Leonhardt wrote an interesting piece covering new research from Christopher Malloy of London Business School, Andrea Frazzini from University of Chicago, and Lauren Cohen of Yale. Entitled “The Small World of Investing: Board Connections and Mutual Fund Returns,” the research basically finds that mutual fund managers are more likely to buy stocks and take larger positions in companies that are in their academic network. Further, these money managers perform substantially better than funds that dont buy stocks in their network.

The data:

Yowza! Over 8% per annum difference! These guys beat themselves up for small fractions of a single percentage point return.

The authors conclude thats its either insider trading, ease of information gathering by being in the network, and better manager selection by investors due to network relationships. Intuitively all seem correct but the split is, of course, the rub. (I blog about this some more here.)

So I find this really interesting because it assigns dollars to the value of networking. We all know its important but who would of though that the difference was so large? Sure some of this data includes illegal activity but I think we now have a solid benchmark of networkings value. How does 70% more money sound to you? Its easy to see why social networking sites have been all the rage and why it is imperitive that all you old-schoolers who think your physical network is all you need, need to think again - especially if you are selling lofts to hipsters and not mansions to grand ma. Come on, get connected and get rich!

Who you ask? Banksy is a UK based artist that has largely used the streets of London as his canvas. Yes, it is graffiti. But really it is so much more. His manifesto gets to the point. It is political and social satire simply executed. The process of having to create a piece of art in a handful of minutes means that the art has to be direct and to the point. Nothing is wasted or indulgent. Banksy is, I guess, reminding us about the state of things and the state of our humanity. Or he is just another opportunitist media whore and I am a sucker.

Banksy was the subject of an article in the New Yorker entitled “Banksy was here” by Lauren Collins. My favorite quote:

“Imagine a city where graffiti wasn’t illegal, a city where everybody could draw wherever they liked,” he once wrote. “Where the street was awash with a million colors and little phrases. . . . A city that felt like a party where everyone was invited, not just the estate agents and barons of big business.”

So the question is why am I saying be like Banksy? Well, his art is simply reminding us, if I may be so bold, to be ourselves again and to take back the world from the stories we are told by people we don’t care about. People, typically, that run crap brands that make promises like “eat me and you will be happy (but fat)” or “buy me and you will be beautiful (but poor)”. We own the world and we will think for ourselves. Bring a point of view and decide for yourself. Look around and see what is happening. Do you approve? Feels somehow like I am just waking up and feel like the one guy who wasn’t in on the joke.

Okay so I am not some lefty anarchist. In fact I am the opposite. I believe markets are an underutilized gift (clearly). I also believe certain institutions and government have a key role. But my hope is that the artificial value being extracted by incumbent businesses based on false promises - promises that most people have been brainwashed to believe in - are over. The internet is changing the way we do business and everyday people will benefit. Will you be a force of change or will you help enslave another generation of suckers?

No not what you are thinking - not social, ethnic, or racial discrimination. Redfin discriminates on price. PRICE! The 60 minutes piece was a yawn for me personally but it does give Americans the right to start to push back. See the posts and comments at TechCrunch, Redfin, Inman, BloodHound for an early read. Whether it becomes a consumer zeitgeist or fades will be seen but the open question is this: will price variation become mainstream in american residential real estate?

There is an old economic idea called price discrimination that is popular with every micro-econ 101 student, and their professors, that says you reach more customers and make more money by offering variation in pricing. Its sort of definitional for anyone who believes in supply and demand. It works like this: when you go to see a baseball game, there are a 100 variations in pricing to meet everyones needs and to tap into every possible cross section of demand. For example, there are ticket prices for corporations who entertain in luxury boxes and ticket prices for those who mostly prefer a beer and some sun in the bleechers. Ticket prices for season holders and ticket prices for last minute shoppers. In short, EVERYONE can have their demand met for baseball. A small example with the mighty SF Giants here.

What would happen if every ticket was the same price? Mayhem and lost profits. Some people willing to pay more for MLB tickets will transfer their money to an underground marketplace that will use price discovery to allocate tickets. Meanwhile, people at lower price points will be shut out resulting in further lost revenues to MLB. Thats why we have pricing variation. Its better for everyone because everyone gets an allocation and the business folks maximize their revenues.
People might argue that the price variation exists is in the underlying house price and not in the intermediary execution price (brokers & agents). If that were true, then why did trading volume in financial markets explode when electronic execution came into acceptance? (For a slightly more technical explanation {very slightly!}, see my earlier post here).

Redfin discriminates. So do I. It makes sense and it is better for everyone. Many people have commented that Redfin basically passes their work load to external agents to facilitate their transactions and to make their business model work. I can certainly see how that might play out. But if the consumer is footing the work load “bill”, don’t they deserve to get a rebate? Don’t consumers deserve the right to choose their level of service? In the end I believe that consumers will still depend on full service agents because housing is complicated and its something we do rarely. But by offering price variation, we get to grow the pie. Anyone else out there a discriminator? Anyone else want to make more money?

Trulia took a big step into socializing camp by creating a Q&A platform with the help of Pat Kitano. Very sharp looking implementation that now solidly takes Trulia from exclusively broker centric to also being agent centric. The list of reviews worth reading follows: Pat Kitano, StartupSquad, TechCrunch, Joel Burslem, Greg Swann.

Trulia’s implementation is clean and certainly ups the feature ante but is basically catch-up with others including Zillow and My-Currency. User generated content is interesting and valuable but is this going to turn into some sort of vertical social networking war where winner takes all? The audience of home shoppers currently is much older and much more tech phobic than what you might see at typical social networks so what the hell are we all doing? Is this web2.0 hipsters flexing, an investment in future behavior by home buyers & sellers, or part of some master plan to disintermediate the existing ecosystems? All three isnt a bad guess.

For a while I have been wondering which direction Trulia would point their ship - towards the incumbents or away?. It feels to me like listings are a commodity waiting to happen and so the question for listings aggregators, like Trulia, is what next? Going social gets them on plan to taking Zillow head-on without alienating their existing constituents. Zillow has ignored the brokers while Trulia has made them their buddies. Each has their natural advantages and disadvantages but Trulia’s is a safer and more optionable route. Only if you raise a bunch of money can you take the path Zillow is taking. The payoff for Zillow, however, is much bigger with the risk because the consumers are the customers and Zillow does this very well. The real estate industry will never go back and the question I have as an entrepreneur is which strategy will win? One that eats its way through the ecosystem (Trulia) or one that completely goes around it (Zillow)?View blog reactions

The Washington Post has a hilarious (but real) article discussing the inside of New Century Financial - the sub-prime mess to end all messes that is now bankrupt. I first read about the article at Inman blog, entitled You WILL play ball. Below is a WP sampler:

“The stress in that place was ungodly. It was like selling your soul,” said Hardiman, who worked for New Century in 2004 and 2005. “There was instant notification to everyone as soon as you rejected a loan. And you dreaded doing it because you paid for it. Two guys would come with a bat, and they were all [ticked] off because you cut their deals.”

I have posted several times about the conflicts between the appraisers, lenders, and agents here, here and here. Bottom line is that it may be time for buyers to hire their own appraisers. This doesn’t represent a new expense but rather a disaggregation of a current expense. If a buyer uses cash, rather than having the costs buried in other transaction costs, than the buyers can control quality and appraiser can get on with their jobs with conflicts.

Also, we might consider the conflicts from the lending side as to communicating affordability to consumers. Does it make sense to expect a lender, who is commissioned based on the number of closed transactions, to actually protect the customers side of the equation? I suppose the logic is that its the banks money but in truth, lenders sell loans and loan agents get new jobs. So the buck gets passed, Wall Street just play the odds (and gets a commission), and the financially illiterate get stuck holding the bag. Nothing new from “big business” but certainly NOT something part of the new business models powered by the internet - including ours.

The solutions to these and other vexing consumer problems are being addressed by market forces. Entrepreneurs like us see this problems as opportunities to add value to people by being open and transparent about our businesses. We put people at the center of our model and drive everything to satisfy this focus. Gone will be the days when trapping and or tricking a customer into a piece of business is THE model. Gone will be the oligipoly’s upon which many incumbent industries are based. Power is being pushed down to people and the economics will follow. Selling your soul in sub-prime, or any other industry, is a dinosaur waiting to happen. A lot of other charts will look like the one below over the next few years.

Yesterday, Russel Shaw at Bloodhound Blog posted a note he received from a young person sniffing the real estate industry. Entitled “I’ll bring you a big basket of cash if you’ll let me sell your house for free” Shaw responds to the young persons overt question whether the industry is crowded and the covert question as to whether pricing can be used as a competitive weapon. Shaw tells the young person not to use pricing to differentiate (and yes there are too many agents). This got me thinking. If EVERY industry has price discrimination, why doesn’t housing? (yes there are firms like Redfin and FSBO’s but traction is light) This is not whether orange people get better prices than purple people. Not that kind of discrimination. This is you using e-trade for stock execution rather than Morgan Stanley. Does variation in transaction costs make sense for housing?

I am not an economist but here goes.

The graph above is what Shaw is saying. There is one price for transactions (or something like that) and that you should stick to it. An economist would say that given the demand at that price, sales will be S1. Lets see if we add new prices…..

So by adding new prices, we tap into a larger amount of the total demand. From an industry perspective, price discrimination (price variation) yields HIGER total number of transactions. This is why airlines use it. This is why software companies use it. This is why EVERYONE uses it. Ever clipped a coupon? Ever cashed in on frequent flier miles? This is price discrimination at work.

So the one thing to consider that might debunk this basic economic notion is whether the demand curve (in blue) is in fact oddly shaped. Lets take a look….

So if demand is the same regardless of price then Mr. Shaw is correct. In fact, if demand in the real estate industry is oblivious to transaction costs than Mr. Shaw and all the other realtors are bloody idiots for not raising prices. So I guess the question is this: is demand for housing sensitive to transaction costs or not? If it is, like most things, then everyone stands to be better off by offering differing levels of pricing (and service). If demand for housing is not sensitive to transaction costs…then put your orders in for those new german cars because margins are about to get much better.

Giddy up little doggy!