Monday, January 14, 2008

Relative Vs. Absolute: Part I

There are different ways of measuring quality or liability, and for the most part you see two methods--relative and absolute. The relative method is based on percentages. A Hollywood agent typically collects 10% of an actor's earnings. The absolute method is based on hard numbers. A contractor charges six thousand dollars to build a new deck or an attorney charges three hundred dollars an hour. Current methods work well in most instances, but there are several situations where it would make more sense to use the other method--percentages for absolute and vice versa.

Look at realtors. Realtors typically get 3% of the sale cost of the home. Some get four or more percent. During the housing boom, when houses were overpriced, realtors made a killing in the market. And all you needed was a realtor license. It was easy, simple, and quick. If you were a fast talker you could close on a house very quickly, get paid, and move on to the next sale. There is a very interesting chapter in the book Freakonomics about how realtors as a whole are not working for the sellers and buyers as they are for themselves and their profit margin. Realtors will spend more money to advertise and leave their own houses on the market longer to get a better price than a house they did not own. They do not negotiate the price for you, but benefit if you do. So when the housing bubble was growing, realtors were making out like bandits. Now let's take it one step farther. If you sell your house in middle class Podunk, USA for $400,000, your realtor makes 3%, or $12,000. During the housing bubble that house might have sold in less than ten days. So an average realtor could easily sell ten houses a year and generate $120,000 in income. Not bad for just needing a realtor license. And certainly aggravating to the rest of the world who work hard to earn their money. Now look at houses in affluent communities. Say Orange County, California, where the show The Real Desperate Housewives of Orange County in taped. Houses there sell for $3 million and up. that would mean the realtor would make at least $90,000 on that sale. I would bet that is a sore point even among realtors.

Perhaps a better way to determine realtor profit is to place a cap on the fee, such as $40,000 or 3%, whichever is lower. I just find it hard to believe that a realtor selling a $3 million dollar house is doing eight times the work or requires that much more capital to sell the house than the realtor selling a $400,000 house. I hesitate to say eight times the expenses because I seriously doubt that it requires that much more money to advertise to a wealthier buyer class.

You could also make the argument that a realtor selling $3 million dollar homes does not sell as many homes in a year as a realtor selling $400,000 or even $800,000 homes, simply because there are not enough "estate" communities. But that is untrue. Even with the housing market downturn, the estate communities are still growing because the wealthy homebuyer has no problem getting a loan and is far far less likely to need a subprime loan. Just as commercial real estate is weathering the subprime fiasco, so is the estate community.

There are similar inequities in other professions. A very common problem is that of lawyers. A large driving force behind medical malpractice cases is that in those cases, the lawyer charges a percentage of the settlement or award won by the client. It is not that people have become more disgusted with medical errors over the years, but that malpractice lawyers, seeking a higher payout, have inundated the public with advertisements promising huge financial compensations for wrongs they may have perceived or for treatments that failed to work. Though one could argue that an ignorant patient would not sue his physician if he was not aware of any wrongdoing, malpractice advertising presupposes that the prevalence of wrongdoing is unrealistically high. In many cases, the amount of damages requested or even awarded is arbitrary. And who can really show that with the growing knowledge that the lawyer will get upwards of 10% or more of the damages, judges and juries are not subconsciously inflating the damages they award? It is a very poor system that is feeding upon itself, creating a slowly growing bubble.

Beyond malpractice, there are the class action lawyers. If you have ever seen a class action lawsuit solicitation, it typically has a clause dictating the terms of lawyers' fees--a percentage up to a certain amount, or else a minimum on how much each client will receive in damages. Depending on the costs spent soliciting cases and due diligence to ensure true clients, each class action lawsuit can net hundreds of thousands to millions of dollars. Which also means that the defendants are almost always cash rich large corporations. Granted, if there was a dollar cap on lawyers' fees for malpractice or class action lawsuits, the majority of these cases would never see a sheet of paper with a law office letterhead. This could mean that the few true wrongdoing cases would otherwise never be settled. So as with employee drug testing, you test all the employees rather than wait for someone to overdose on the job. But the current practice of malpractice and class action suits is more akin to putting everyone on a methadone wean and then searching their belongings for drug paraphernalia.
It's much to costly on the system and public and reaps little rewards for anyone. Perhaps a percentage of the award up to a dollar cap may work as well for these suits. It might help staunch the oozing of greed into case solicitations and shift more money to the winning parties, especially if they deserve it.

There are so many other examples of inequity between relative and absolute systems around us, but that is for another day.