Have you ever wondered why many mortgage brokers and real estate agents try to hard sell you on a property or a unique mortgage? Those with dogmatic views usually try to convince themselves as much as they try to convince other people; they have a vested interest in believing that nothing negative can ever happen to real estate. And with this, you create a business culture where anything goes and financial prudence is thrown out the window. And speaking of windows, this brings us to the Broken Window Theory and how it applies to the current housing market.
The Broken Window Theory Applied to Housing
George Kelling and Catherine Coles, both criminologist studying petty crimes in urban areas found that fixing minor public nuances like broken windows and graffiti greatly helped to eliminate larger crimes. They argue that the perception of broken windows and graffiti for example, lead people to believe that the area is unkempt and thus opens the opportunity for criminals to commit even graver crimes. The psychology to this principle is simple yet profound. The environment has an unbelievable influence on how people react. With cleaned up environments they found that the “gateways” for crime were eliminated and thus fighting petty crime such as broken windows is very important in the overall health of the area. It is important because it creates the impression of law and order.
This is absolutely important and has many parallels to the current housing market. The broken window in the housing market is the credit bubble and the direct relationship with mortgages. With the credit bubble, the environment was shaped to support progressively more risky mortgages. Even though the Fed and government would like you to believe that they did not encourage the housing bubble they did. Consider the Fed as the local governance of a community that actively let graffiti and broken windows prevail only to be in shock when they realized crime went up in the progressive years. How can you blame a broken window for more serious crime they ask? And with this, those at the bottom of the pyramid got the implicit message that it was okay to lend money out on risky terms because they had the okay from those at the top. Again, never will you see the Fed openly admit to this blessing but their actions speak louder than words. They essentially let the environment go, like a controlled experiment in a lab, and now are seeing the fruits of their irresponsible actions.
Many want to assign the blame to those at the lower rungs. Make the buyers, sellers, agents, and brokers pay. But what about the government who receives fatter checks from properties that are appraising higher? Or what about the Fed who is still able to claim low inflation and a stable economy? The broken windows of mortgage fraud and credit keep growing with no stop. The L.A. Times has written two articles highlighting that 50% of all stated income loans had incomes overstated by at least 50%. What does this mean? A family making $50,000 a year was all of a sudden making $80,000 to fit into that negative amortization loan. That is fraud fueled by a lax environment.
Fundamental Attribution Error
People tend to underestimate the power of environment. This goes against the grain of the rugged individual so many Americans believe in. It comes off as blasphemy to blame anyone else except yourself. On a recent survey, 90% of all drivers felt they drive better than average. This is the crux of the fundamental attribution error. And how this relates to housing is rather interesting. We are starting to see arguments on many housing blogs and the mainstream media about who is to blame regarding this housing debacle? Is it the lending industry for creating risky loans. Is it the realtor organizations for pushing buyers into homes they could hardly afford? Is it the Fed for flooding the markets with cheap credit? Or is it the buyers for signing on the dotted line? I think blame is never a black and white argument. Usually all parties have something to gain in a bubble. After all, without the signature of the buyer the home would never sell. Yet without the easy credit of the Fed, there would be no discussion of risky mortgages and the mass appeal it currently has.
We are now hearing horror stories coming out from organizations like New Century Financial. The environment seems like a frat party gone bad and scenes from Wall Street come to mind. Some whistleblowers are quoted as saying that they felt “pressured” or “coerced” to join into the herd mentality or else. Again, their rhetoric highlights the power of environment over the individual. Many would like to believe nature has no impact on how we interact with the world. This is false. If the Fed had never injected easy credit into the market the bubble would not be where it is today. The Fed and the Mortgage Backed Securities (MBS) market created an appetite where these vices would be fed. No longer are we grounded on any economic theory or can we use real estate valuation tools because we are in a bubble; and by definition a bubble cannot be defined by rational tools. But don’t be fooled by only blaming unscrupulous agents, brokers, or naive buyers; the blame needs to filter up to those that created the filthy environment where the broken windows of housing were ignored.
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