A Predictable Crisis

With apologies to Gail Sheehy, the current real estate and mortgage market crisis is nothing more or less than a predictable crisis in the adult life of these markets. It parallels almost exactly what happened in the stock market in the 1920s. Then, buying stock in local companies on local exchanges based on personal knowledge had been eclipsed by transactions on the Wall Street exchanges based on unverified claims and trust. In our day, local finance of local real estate was eclipsed by buying pieces of pools of mortgages assembled nationally and backed by mystery real estate based on unverified claims and trust. In each case, the development of information systems lagged the development of national trading mechanisms. As a result, all the players in these markets were pretty much operating in the dark. Bad things happen in the dark.

What kind of bad things happen?

First, people assume things to be true that, if they were, would create value. They bid on the basis of that assumed value. Unfortunately, the assumptions turn out to be false.

Second, some players in the market intentionally create illusions of value in order to fool prospective buyers into believing that something is more valuable than it really is and pricing on that basis. 

Third, information about the trading takes the place of the nonexistent information about the underlying asset. A claim to value is then supported by the fact that another occupant of the dark has paid such-and-such for it.

Every one of these situations sends the wrong signals to everyone else in the market which then does an increasingly bad job of setting prices on things that accurately reflect underlying value and risk.

If there is a lot of money floating around, this can keep up for quite some time before the-emperor-has-no-clothes moment when the lights go on for some reason and the claims to value are exposed as having no basis.

The correct response to the current crisis is to build an asset (in this case, real estate and mortgage) information system adequate to the demands of a globalizing mortgage market. As Louis Brandeis once said: "Sunlight is the best disinfectant."