Wisest of the crowds

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?

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?

This Redfin Consumer Bill of Rights thing got me thinking …Glenn has it all wrong. Here is my list:
1. Shut your pie hole! You get the services we prescribe. One size fits all.

2. Shut it! The way your agent makes money is his or her business even if it results in misaligned incentives ( this is an economics doohicky that means giddy-up!)

3. You are committed to an agent if that agent saw you first or called it first. Next time wear your cloaking device idiot.

4. Your agent’s job is to put lipstick on the pig. All other services are redundant and therefore easily dismissed….cut your own #$@!ing grass!

5. Agents are trained by Jedi Masters to find that singular point of harmony between a buyers and sellers interests….plus money more is better than less (duh!).

6. There will be no commission refunds. Full stop.

7. The only houses for sale are the ones your agent takes you too see….trust them implicitly.

8. Have an open discussion about a house for sale… as long as it is in your toilet and by yourself. We will not tolerate free speech in NARmerica.

9. See only partial information available about a house for sale. Too much information confuses you silly little consumers. Here, have a lollipop!

10. Be sure your agent will show your house to everyone but the cheap bastards that will never pay the sticker. Good agents can tell..trust us.

Redfin, a real estate start-up that is known for shaking things up a bit has launched a new initiative entitled The Real Estate Consumer Bill of Rights. Redfin CEO Glen Kehlman shows a lot of courage and perhaps even more media savvy by undertaking this effort. I will spare you the details, so here is the list without the explanations he provides:

1. Choose the services you pay for.
2. Know how your agent makes his money.
3. Know when you are committed to an agent.
4. Know what services your agent will provide.
5. Have an agent that represents only your interests.
6. Know the commission refund you can get before you buy a house.
7. See all the houses for sale.
8. Have an open discussion about a house for sale.
9. See all the information available about a house for sale.
10. Be sure your agent will show your house to everyone.

A lot of people have spent considerable time weighing in. Notable positive reviews include Kevin Boer of 3 Oceans Real Estate ,and Joel Burlesome of Future of Real Estate. Notable undeclared bloggers are and Ardell Dellaloggia of Rain City. Notable undeclared bloggers include Christine Forgione of NY Houses for sale. A thorough and negative review comes from Greg Swann of Bloodhound. All worth a read.

This is a complicated issue that I am still assessing but in principal, I like anything that gets people talking about making things better for us consumers. In this regard, I support Glen’s efforts.

There are some areas that deserve some more thoughtful consideration, particularly when the answer results in a request for MORE legislation. My experience with private Board deliberations versus on-the-ground reality for some of the largest financial institutions in the country is that big business uses big government to create advantages for themselves vis-a-vis their competitors (large and small) and the silent majority of consumers. There is nothing Machiavellian about this reality. Ours is a system that wants all sides to speak-up. Unfortunately, those who speak the loudest (usually via money) get heard. So creating more layers of laws means we make change more difficult and less likely. Also, we cede legislative influence to money politics. When was the last time you paid into a lobbying fund?

Glenn can’t fight the fight with money so he is enrolling the people. Bravo! Is it good for him? Yes, absolutely. Discussion of this is a waste of time. Why else would he propose it? Does this matter? No! Glenn has started a discussion and I am much better informed as a result (are you?). Do I see the validity of some of the arguments from opponents such as separating commission paid by buyers and sellers so that we get better align of incentives and flow of money into the ecosystem? Yes, very much so! So let’s keep the discussion alive and thriving and then let’s demand some changes where we agree. Glenn, thanks for getting us started.

Marcie Geffner of Inman news has a great article (subscription) about the conflicts and misaligned incentives that appraisers face today. I discussed this in an earlier post entitled “inflating appraisals” but essentially I agree with Marcie’s assessment about the state of the industry. Appraisers get pinched from all sides because those people that hire them are incented to get it wrong. A bank lender gets paid on volume. A real estate agent gets paid upon close of a transaction. A seller get more money. A buyer gets a loan, a house, and a sense of fairness (admittedly a false sense of fairness).

That is not to say that all appraisals are suspect or that there is malicious intent at work. But when relationships in the ecosystem are structured such that there will be implicit or explicit pressure on appraisers, the weakest ones will likely fold putting greater pressure on the vast majority who work hard to get it correct. So it is really about shielding the analysis from the commercial motivations of others.
Marcie doesn’t quite get our model correct but that’s ok because it gives me the opportunity to pitch it. Marcie is right to suggest that buyers are probably in the best position to fix the situation by hiring their own appraisers. This is where My-Currency comes in because we identify the experts. If you are an appraiser, how will you ever reach consumers? Through an agent? No, that doesn’t quite solve the incentives issue (”get me the value or I’ll find another appraiser!”). Through a mortgage lender? No, same problem!

My-Currency gives appraisers a way to demonstrate their skills; talk about what you know; answer questions; and make value predictions about houses for sale or zip code indexes (value per square foot or days on market). My-Currency enables appraisers and other housing professionals to show the world what you know and help you connect with these customers. We offer a platform where professionals can build professional currency and hence virtual reputation.

Please let us know what we can do and stay tuned because we have new things to announce that will further our goal of serving housing professionals and consumers.

One of the nice things about creating something that forces people out of the intellectual cave is listening to massive justifications for crap.

For example, one thing that a few people in real estate industry are in love with is this idea that the value of a home is solely determined by the buyer and seller at a negotiation. Further, some are crass enough to suggest, essentially, that value is a nice concept - but that transaction prices are king. Okay, that is true in a vacuum. It is the equivalent of saying the cake is chocolate because the frosting is brown.  The cake can be anything and certainly no one would suggest that the frosting is the cake (except my three year old daughter).
Why do I say a vacuum? Because people enter a negotiation with information that they receive from all around - from every conceivable person they know. That information comes explicitly and implicitly. In economics its called “signalling“. The idea is that we receive information signaled from others during a transaction. I think you are not paying enough for my car, I shrug my shoulders and tell you as much. Do I really think your offer is low? If there were several people between you and me in the negotiation could the signal lose its strength or have its meaning altered?

So our actions are a function of this signaling effect. When you rely on signaling from someone, there are many problems, the largest being:

- How can you, the receiver (the principal, who is usually the buyer in the transaction), trust the signal to be an honest declaration of information?

The problem My-Currency’s CrowdValue technology solves is that we bring to the surface this information signaling that is happening underground. That is, we are putting you into the information loop so that you get all the information signals in an unbiased manner. We know there are people who have incentives to send you the wrong information signal. That is, people who use signaling to manipulate you. Markets (e.g., CrowdValue) come closest to solving this signalling problem because it is an open mechanism that serves as a battleground for opinions where information collides until we have reached a neutral and aggregated signal - the price. Furthermore, markets constantly adjust to new information - new signalling.
Bottom line is that markets enable transparency - transparency for all the information that is circulating and perhaps being manipulated before it gets to you.

Is this good for housing pro’s? Yes because people will have more faith in the system and hence transact more frequently. It also gives pro’s an opportunity to show the world that have information and know how to interpret it - by taking actions that are measureable against real outcomes.

So who determines housing prices? Everyone. Everyone connected to the buyer and seller and everyone connected to those connections. Negotiated transactions are final manifetations of the whole network - the whole process.  Are consumers getting all the information signals? Mostly no (hence the popularity of AVM’s). Is information passing through the hands of people who have opposite incentives and hence opening the question of whether it is an honest declaration of information? Come on, do I need to spell it out?

Today the nationally syndicated Kenneth Harney in the Washington Post and San Francisco Chronicle pens an arrticle entitled “Feeling pressure to inflate appraisals” and sites research done by the October Research Corp:

“A new survey of the national appraisal industry found that 90 percent of appraisers reported that mortgage brokers, real estate agents, lenders and even consumers have put pressure on them to raise property valuations to enable deals to go through. That percentage is up sharply from a parallel survey conducted in 2003, when 55 percent of appraisers reported attempts to influence their findings and 45 percent reported “never.” Now the latter category is down to just 10 percent.”

This is a pretty damning stuff. The incentives to get valuations right are stacked against everyone. The buyer wants the house. The seller wants the price. The agent/broker wants the commission. The mortgage broker wants their piece. The lending officer at the bank wants to make a loan.

So there is a lot of pressure to buy into the illusion. The people whose reputation is on the line is the appraiser and the credit officer at the bank. I am guessing that they get lots of pressure to align their motivatins with commercial needs (money) rather than unfettered due diligence (the truth). In Harney’s article he interviews Alan Hummel of Forsythe Appraisls who states “I call it a perfect storm…You’ve got a situation where sales are down so everybody in the deal needs it to go through”

Hummel and Harney go on to say that the largest offender of this is the Mortgage Brokers who will blackball appraisers if the values do not support the transaction. Furthermore, the flood of new entrants into the appraisals industry means lightly trained appraisers, hungry for business, are easily manipulated.

Hummel concludes that Congress needs to pass legislation to make pressuring appraisers a federal offense.

At this point I must differ with this as legislation can make it both more expensive for consumers and probably not solve the problem effectively. Additionally, with nearly the entire ecosystem aligned with keeping the illlusion alive, who is really accountable? Consumers need to own this issue and engage a market solution. My-Currency is directly addressing transparency of valuations and professional capabilities. Can others be far be behind?

Background on Markets
Let me just start by saying that markets work. They coordinate people efficiently while communicating prices in a transparent manner. That’s why we have financial markets. Imagine a world where you get prices from a single person or a small group of people (sound like housing at all?). Any chance those prices would be incorrect or have artificially large profit margins built in?

Markets are probably among the first creations of man. I can imagine that X thousands of years ago, some guy living in a cave went out and decided to trade his five roots for a leg of antelope and, magically, a market price was established. So 5 roots = 1 antelope leg until demand or supply of one or both sides changes.

So we know markets work and that they have been around forever. They work because they are open, transparent, and continuous! They are living, breathing entities that are constantly communicating the net outcome of all participants opinions and motivations.

What we are doing
My-Currency is leveraging this fact that people can process information better than machines to arrive at value. The premise is that you need FULL information to arrive at value and the only way to get full information is to use a mechanism that is open, transparent, and continuous. Something that ‘sponges’ information and opinion from every conceivable corner and do battle with others.

We go further and we give you a peak into future expectations of housing at very granular levels. You are buyer or seller and trying to decide on timing? Look at our futures markets on zip code value per square foot and see what the community thinks the value WILL be.

Do models work?
Much of the way valuation analysis and modeling is done depends upon backward looking or incorrect data (e.g., XYZ house was expanded in 1995 but the tax records don’t reflect this) as well as general human biases.

Furthermore, the problem with mathematical models, called AVM’s, is that they are limited to sales information, tax records, and economic information. What about less tangible items like the fact that the house next door is falling apart and full of college students having parties? Or that the beautiful building across the street is going to be torn down and replaced with a garage NEXT year? Or just that there is more buyers than sellers at this point in time?

What we solve
The problem we are solving is that people want valuation information as well as contextual information (What is the neighborhood like? What is the community like? What do people think of the schools?). Additionally, consumers who need help have problems differentiating between various professionals – the question is who is smart? Who understands value so that I can get the best deal? Who is clearly connected to the community that I am buying or selling in to give me depth of knowledge to maximize my transaction?

If you are a professional, we provide you with the opportunity to show the world you are smart. We are only interested in revealing expertise, NOT revealing the lack of expertise. So if your predictions or contributions earn you status above median, we will reveal it giving you the opportunity to be discovered by current and future clients.

Gaming & Incentives
There seems to be concern that we haven’t thought through the gaming aspect of using markets. Let me just say, I have been a derivatives trader for 15 years and Vice Chairman of the Pacific Exchange (now part of the NYSE) and so gaming is front and center for anyone in the financial markets – its called, among other things, ‘painting the tape’, ‘cornering the market’ and ‘insider trading’. History is filled with these stories so this is nothing new and I have experienced all of these first hand. This is largely why there are regulations if the financial markets. Have you ever heard of the SEC or CFTC?

My-Currency does have anti-gaming algorithms in place but they are turned OFF because we want to observe behavior during our Alpha period. Long-term, we believe that if My-Currency can grow a large and diverse enough community, we won’t need anti-gaming algorithms because price inefficiencies (prices manipulated to achieve some real world outcome) will be exploited by people who have opposing incentives or those who are motivated by or aspire to achieve reputation. The best thing that can happen, if you are trying to make your mark with community, is to hunt down prices that are misaligned with reality and bring them back into line – and therefore earn community status (reputation currency).

Bottom line: Will there be gaming? Yes - even the financial markets observe this. Can gaming be managed? Yes – explicitly through our algorithms and organically through community.

Aggregation of users
Markets need people. If we don’t get people to come then we wont have markets. The number of people for a market to succeed is not that large – probably as few as ten. The markets for a single house have an excellent opportunity to exceed this number. A typical open house in San Francisco will get 50 – 100 agents plus their clients, neighbors and voyeurs. So the total potential audience is in the hundreds for a house. For our indexes, clearly it is even larger and has more relevancies for a broader base of users.

Also, please consider how things occur now. As a buyer or seller, you will get your valuation information from a computer model and your agent. I suppose the question is, would you rather have a small group of people who are motivated by building and maintaining a public reputation give you their collective wisdom or depend on a black box sitting in a basement in someone’ office? Perhaps the word of an agent whose skill set isn’t transparent is better?

My-Currency gives you the opportunity to both get that wisdom of crowd values as well as the wisest of the crowds vetting – that is, it gives you who makes the best predictions and who therefore who are the experts.