Some years ago a friend of mine, let’s call him R, purchased a condominium unit in the east. It was a two bedroom unit located on the 9th floor, right next to the mrt station and a short commute from where he and his girlfriend would both work.
He had seen a number of units in the vicinity, and was ready to commit. He made a sincere offer just slightly below the asking and kept his fingers crossed.
The agent whom R was working with, happened to hold the exclusive rights for the unit and R did not have to wait long. According to the her, they already have an offer higher than his. But that was from a colleague co-broking the deal and accepting that offer would mean sharing and halving her own commission.
She suggested to R that he increase his offer slightly, and on her part, she would embargo the other offer and present his to the owner and strongly recommend that they accept his offer. This was despite the fact that my friend was not the one who presented the highest offer.
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The house was eventually sold to R, the agent pocketed her commission and the sellers and other bidders were none the wiser. It has been five years since he bought the house. He has since gotten married to his ex-girlfriend (now wife) and they are proud parents to a beautiful baby girl.
We would visit often, and occasionally when properties come up in our discussions, he would voice out that he felt bad about depriving the original owners their rightful price for the property. Other than that, we all considered the episode closed.
In his new book Antifragile – How to live in a World we don’t Understand, Nassim Taleb reiterates and intensifies his calls for the basic principle of having ‘Skin in the game’ when it comes to regulation of the entire financial industry. He suggested (‘insisted’ is perhaps more appropriate, given his forceful personality) that the financial crisis of 2007/08 happened precisely because the decision makers are detached from the consequences of their flawed decisions.
Taleb uses a Hammurabi code originating more than 4000 years ago to illustrate his point,
‘If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, the builder shall be put to death’.
The Babylons clearly understood risk intrinsically. There is no doubt that the builder knows more about constructing the building than the person that is to eventually stay in it. Without the social contract, the builder could cut corners, maximize profits, and construct a house that stays up for as long as it takes for him to hand over to the owner.
The code shifts the burden of responsibility onto the builder and align the interest of both parties. Both builder and owner are now on the same page, and it is in their every interest that the house remains standing for as long as possible. In an academic paper that Taleb co-wrote, he states
‘The potency of the classical rule is that people do not wish to consciously harm themselves… …This principle has been applied by all civilizations, from the Roman heuristic that engineers spend time sleeping under the bridges that they have built, to the maritime rule that the Captain should be the last to leave the ship when there is a risk of sinking.’
Social scientists term it the ‘Agency Problem’. This problem arises when the interests of the agent does not align with the interest of the Principal or client. Hence, even though the agent is expected to take the best course of action to benefit the client, self interest would be the foremost consideration and the agent would act to preserve his or her own interest ahead of everything else. (The term ‘Agent’ is used in a broad concept here, and is not only limited to housing agents mentioned above). In fact, as Taleb would argue, the prevalence of this is causing systemic, deep rooted problems with our financial systems.
I look around at my investing and trading environment and I would be hard pressed not to agree with him.
In Singapore, property agents representing sellers are not paid a fixed sum upfront to market a property. Rather, they are paid a percentage, usually in the region of 1 to 2% of the final transacted price by the seller of the property.
Now this presents two conundrums. First up, the agent gets to pocket the entire sum if the buyer is unrepresented, but if there is another agent representing the buyer, the seller’s agent is obliged to split the spoils with the buyer’s agent. It is in the homeowner’s best interest to sell the house to the highest bidder. It is in the seller agent’s interest, like in the case of R, to ensure that the property gets sold to her own buyer, regardless of whether they bring the highest offer to the table.
University of Chicago economist Steven Levitt and New York Times journalist Stephen Dubner pointed out in their 2005 bestseller, Freakonomics: A Rouge Economist explores the hidden side of Everything, that after examining the data for housing transactions in the Chicago area, they discovered that houses marketed by agents who are the owners themselves remained on the market for an average of 10 more days and sold for an average of 3% over all other transactions.
Selling a one million dollar house with a 2% commission payable would net the agent $20000 in commission. Selling the house for $900 000 would see commission dropping to $18000. If there is an offer for $900000, advising the owners to hold out fora few more days to try and achieve their asking price in its entirety might mean putting $18000 on the line for a potential $2000 extra; hardly a wise move. Hence, the agent would be eager to close the deal and lock in the bulk of the profit that is already on the table – often at the expense of the seller.
The banking industry operates in a slightly different but very similar fashion. Try depositing a significant amount of money at your local bank branch. Chances are you will end up being accosted by sales representatives, wealth managers, relationship managers inviting you to consider ‘investing’ in higher yielding instruments.
While banks claim to always safeguard your interest and representatives always declare their fiduciary duty towards your finance (i.e. he or she will handle your affairs just like their own), the fact of the matter is that there is no alignment of interests at all. The representative makes money when you buy something from him or her. You make money when the product does well. You lose money when the product does not do well. The representative loses money under no circumstances.
There is a moral hazard involved because, according to Taleb,
‘the actor has an incentive to behave in a suboptimal manner because he or she does not bear all the actual or potential cost of her actions… …Nobody should be in a position to have any upside without sharing in the downside, particularly when others may be harmed’.
And almost as if they heard his call, HSBC just two days ago became the first bank to scrap sales commission for some of its bankers, switching to paying out bonuses for good customer service instead. A HSBC spokesperson said
‘We want to build long term and sustainable relationships with our clients, and in order to meet our client’s needs, we are actively reviewing how we reward our wealth sales team’.
There will no longer be sales target to meet, which means one’s sales performance has no bearing on his bonuses. In doing so, client’s interest should come to the forefront once again.
Traders of Contract-for-Differences will no doubt be familiar with the terms direct market access (DMA) and market maker (MM). Fundamentally, DMA brokers route your orders to the market and receive a commission for executing the trade. There is complete transparency and no middle man adjusting prices. MMs operate on the other extreme of the spectrum. As the name suggests, they ‘make the market’ for your orders.
You could place a CFD order for one lot of SGX through a market making broker. Instead of going to the market, they might be filling your order internally with other clients or even themselves on the opposite side of your trade. If it is the case that the market maker is betting against you and may profit directly from your trade, one wonders how then, could they be protecting your trading and investing interests at the same time.
Some BigFatPurse readers are industry professionals; real estate agents, relationship managers with banks, financial advisors and remisiers. The standard retort (not that I am asking for one) I will end up getting is ‘oh, there will always be black sheep in every line’ and ‘oh, we are definitely not like that’.
That is not the point. This isn’t about individuals. It is about a structural deficiency in the way our financial markets operate, one that Nassim Taleb has highlighted and HSBC has recognized. And as traders and investors, it is crucial for us to be constantly aware that many parties and many elements we deal with in the course of our activities have interests that are not aligned with ours.
It is our own responsibility to protect ourselves, because if we do not, no one else will. And only one thing in the world will give us that power to protect. It begins with the letter K and ends with the letter E. (Nope, not kryptonite. good try).
Some months ago, R was surfing Facebook and out of curiosity decided to look up couple who sold him his unit. With minimal effort, he located the husband from his name in the sale and purchase agreement.
Looking through his pictures and that of his family’s, he saw the exact same agent who brokered the deal, the exact same agent who claimed to have protected his offer, the exact same agent who claimed to have made the owners think it was the only offer they had, the exact same agent whom he trusted to protect his interest and negotiate for a fair and just price for his apartment, posing in many of the pictures with their two lovely kids.
They are a happy family indeed.