What makes an IOU worth anything? As Peter R. Fisher points out in a very interesting op-ed in the WaPo this morning, the likelihood that it will be redeemed can have two very different sources, which he describes as asset-based and cash-flow-based underwriting. Asset-based security is based on something the borrower promises to give you if he can’t or doesn’t pay what he promised. This could be a house, or a bunch of common stock, or a box of tulip bulbs. To make the loan, the lender has to believe the price others will pay for the asset will increase or at least stand still, but doesn’t have to make any judgment about the borrower (except that he won’t split for Brazil with the asset in his suitcase). So you’re putting money out on assumptions about the behavior of zillions of people you haven’t met and know nothing about, with no attention to the character of the borrower himself. This seems odd: the “behavior of zillions of people” is not, in the end, like the “behavior of zillions of gas molecules” on which we bet our lives every time we fly. Stupid gas molecules, good; stupid investors, bad.
Cash-flow security is based on the lender’s expectation that the borrower will create enough new value (that others will pay for; no escape from risk, just managing it) to pay off the loan. A business loan to an entrepreneur, or an investment in his new project, is cash-flow based: the borrower has to tell the lender a story, with sufficient evidence, about how he will succeed in the enterprise. There’s no existing asset to seize – a couple of laptops and some second-hand furniture? – so the loan is a judgment about capacity. Buying stock in a big company, or lending to it, is actually similar: stock prices reflect an expectation of future capacity to create value, not an evaluation of liquidation asset value unless things are already in the toilet.
Fisher says finance has evolved from mainly cash-flow to mainly asset based, and why this matters. Current asset value lending is a bet on a market making a judgment as ill-informed about the flow of value to be expected as yours: that McMansion a two-hour commute from the city may have just sold in a frenzy for $2m, but can it really provide housing services each year whose net present value is $2m? And shouldn’t the buyer’s job prospects have something to do with your risk? Art prices display this nuttiness: a ten million dollar painting has to be worth thousands of dollars an hour to look at (how many people can crowd around a painting and get anything out of it? How many actually ever do, for anything but the Mona Lisa?) eight hours a day forever, or the price is nothing but a bigger fool bet.
Cash-flow investing is a bet on something much more solid, but it takes work to do it right and some real knowledge of a person, a real estate market, or an industry. Because it forces the exchange of useful knowledge about how complicated things work, it builds social capital and in the end it’s much more secure. Asset based investing is ignorant of lots of important stuff and deeply asocial (the data you need is a bunch of numbers going across a Bloomberg screen) and turns out to be flaky.