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Lessons from Those Who Predicted the Housing Bubble - and from Those Who Didn't.

by Dov Gordon

A New York Times article (March 2^nd, 2008) titled “How a Bubble Stayed Under the Radar” by Robert J. Shiller, tries to answer the puzzle of why “…most experts didn’t recognize the [housing] bubble as it was forming?”

Shiller suggests that the reason consumers continued to bid up home prices and didn’t recognize that prices were inflated was due to the impossibility of any single player having all the information.  So even if an individual suspected that homes were overpriced, he was very likely to have passed on his own judgment for that of the masses.  He relies on a model called the “information cascade” which shows that “more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.”

 “…If people could somehow hold a national town meeting and share their independent information, they would have the opportunity to see the full weight of the evidence. Any individual errors would be averaged out, and the participants would collectively reach the correct decision.”  In other words, if only we had all the information we could make better decisions.

Well, maybe.  But in real life we often need to make decisions with incomplete information.  So what to do?

Yet, there were those who did predict the housing bubble so if we can reconstruct their thinking, it should be helpful. In the May 2006 issue of Harpers, Michael Hudson analyzed “the coming real estate collapse” more than a year before the crumble.

My friend Stever Robbins summarized Hudson nicely on his blog back on April 28^th, 2006: 

“…Banks are writing more and more mortgages on inflated house prices to people who don’t make enough to pay off the loans. People are paying interest-only loans or even partial-interest loans, so they are never building any equity. If prices level out or fall, those people are doomed. They can’t sell the house for enough to repay the loan. So they’re stuck. If interest rates go up, then they can’t make their monthly payments either, and their only recourse is bankruptcy. If this happens enough, the banks are screwed because they lose the money they loaned.”

Stever proceeded to lay out an insightful, logical and sadly correct conclusion about the direction of the housing market and the resulting impact on the banking system.

Did Hudson and Robbins have more information than Fed chairman Alan Greenspan who “would tell audiences that we were facing not a bubble but a froth — lots of small local bubbles that never grew to a scale that could threaten the health of the overall economy.”  Certainly not.

Making good decisions and recognizing trends isn’t a function of having all the information – as if such a thing were possible.  It’s a function of understanding the information you have; of recognizing what information is significant and what is incidental.  Poor decisions are usually caused by inflating the importance of the wrong details and brushing aside what really matters.

When studying the housing market, which information really matters?  What factors are driving all the others?  What makes the mortgage industry tick?

By taking a broader view, by expanding what we pay attention to, we notice that consumers can’t bid up a house without the backing of a bank.  If we then look at the publicly available information on the banks, we might start to notice, as Hudson did, that banks are writing more and more loans to people who can’t afford them.  We might notice that loan defaults are on the rise, but banks are allocating for fewer and fewer.

My point is that to accurately predict trends and make good choices, we don’t need all of the information, but we need to pay attention to the RIGHT information and give it its proper weight.  You do this by asking smart questions that broaden the scope of what you are paying attention to.  You ask questions that help you draw hypotheses about causality and project forward.

Being smart doesn’t ensure good judgment.  Good judgment also requires clear and disciplined thinking. In a future article we’ll take a closer look at these kinds of thinking skills.  For now, consider these questions below…

DOV GORDON’s CEO THOUGHT-PROVOKER™ SUMMARY:

1. What factors, trends or information has been playing a key role in your company’s decision making during the past year or two.  What might cause those factors to be more or less relevant in the future?

2. The converse:  What factors have you been downplaying but which might deserve renewed consideration?

3. Since the current trajectory can’t continue forever, what are three or four possible future scenarios and how can your company leverage each should they in fact develop?

4. What is the uniform decision making process followed throughout your organization?  Does one exist?  Does it force objectivity over wishful thinking?  Does it ensure decisions are made in line with your company’s strategy?

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DOV GORDON helps senior executives make better, wiser decisions and quickly get things done.  He is sought after for his perspective and advice on formulating and implementing strategy, developing an innovation culture and cultivating superior team work.  Dov can be reached via his websites www.GordonGroupEC.com and www.Superior-Strategy.com or via email at dovgordon@gmail.com.

Archives of The CEO Thought-Provoker™ are here:  http://www.gordongroupec.com/articles.html

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Dov Gordon helps senior executives at small and mid-sized companies around the world to earn the respect and admiration of their marketplace.  Clients benefit from clarifying their strategies, sharpening their focus, better decision making, improved teamwork and growing into great leaders.

Management and Strategy Consulting.

Executive Coaching.

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Copyright 2008 © by Dov Gordon.  All rights reserved.