An Expert Opines on Expert Opinions (Market Forecast by Jeff Collins)

I am beginning to doubt what the term “expert” really means. First, in the interest of full disclosure let me state that I have been called an expert. In the last couple of decades there has been a rampant proliferation of consulting firms, think-tanks and professional advisers. One has to wonder how much of growth in our Gross Domestic Product is a direct result of the activities of experts. Of course, as we spend billions of taxpayer dollars to right the wrongs of the experts it seems a fair question to ask, “What did we get for our money?”

I recall a line from the movie “All the President’s Men” when “Deep Throat” advises Woodward and Bernstein to “follow the money.” If we take that advice we start with the initial transaction, the purchase of a real estate asset. That purchase has certain characteristics. The most important of these are the ability of the borrower to meet their obligations and the quality of the asset. Let’s examine the borrower first.

The quality of the borrower is determined based on their current economic status and past performance. Do they pay their bills? How much income do they bring home on a periodic basis? What is their capacity to perform in the future?

You get the idea.

Now, if a financial institution chooses to make a loan without getting this information or to someone whose information indicates their current status or past performance is sub-standard then the lender is forewarned.

The trade-off, of course, is in terms of rate of return to the lender or conversely, the rate the borrower accepts in exchange for the loan. Surely, an expert makes the decision as to the expected rate of default and the rate of return required to compensate the lender for taking on such risk.

The other side of this transaction has to do with the quality of the asset. That is the responsibility of the appraiser and the lender. Appraisers are primarily dependent on like transactions to determine value. Adjustments are made for idiosyncrasies of the property and market conditions but mostly appraisers look backward. Financial institutions presumably monitor market conditions and have some idea of overall trend. That is, lenders make decisions based on expert opinion of future trends in value. These trends are supposedly rooted in expected changes in supply and demand for real estate assets.

At this point, assuming the loan stayed with the lender, the experts at the financial institution would be tied to the outcome of their decision. Bad decisions would be punished and the pain would be felt by those that made the decision and those responsible for hiring and policies that allowed the behavior in the first place. It is less clear how appraisers who perform poorly are punished, if at all.

Through securitization, detail is lost about the risk associated with each loan but by packaging loans together and selling the bundle as a security, diversification presumably mitigates some of the risk involved. Investors purchasing these securities engage experts who provide counsel on the relationship between risk and return. Investors bear the cost of bad decisions but like appraisers, those that provide information are not directly punished for bad information.

Finally we come to people who insure investors against loss. That is, firms that sell insurance against default by the borrowers whose loans make up the bundle that is sold as a security. These companies are the farthest removed from what market conditions on the street where the house is located.

However, as mistakes are made in the estimation of risk along the way, estimations that are the direct result of highly compensated experts, the exposure of investors in securitized real estate, companies that insure investors against loss by insuring against default by borrowers, and finally, investors in the insurance companies themselves is amplified. What really makes this a house of cards is the degree to which each party uses leverage to facilitate transactions.

In the end, we have to look at who pays for the sins of the market. Homeowners, banks and their investors, and insurance companies and their investors all experience loss, but the multitude of experts whose advice served as the mortar for our house of cards throw up their hands and say, “who knew?”

The obvious answer is, “certainly not you.”

(Jeff Collins, Ph.D., is an economist and partner in Fayetteville’s Streetsmart Data Inc., which produces a quarterly report on real estate in Northwest Arkansas. For more information, call 479-872-1000.)