More on value

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.

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.

Sunk costs and recoverable costs: the bailout

The bailout is not about recovering financial losses: those are just recording real losses that can’t be recovered. It’s about recovering the most important economic resource, the social capital of trust.

What, exactly, has been lost in the financial wreckage of this interesting week? How much will the bailout, whatever it turns out to actually be, cost taxpayers? The answers are not what you would guess from the public discussion: in both cases, not as much as you might think (though pitfalls surely remain in the path ahead).

But first, a reflection on what a loss is and isn’t. Loss is when economic resources go away. Economic resources are stuff and capacities. The stuff is obvious: your house, your refrigerator, the food in your refrigerator: capital goods and stocks of material. Capacities are resources too: the recipe you’ll add value to the food with is an economic resource, like your ability to do work people will give up resources for. One really important resource that doesn’t get sold (like your house), or rented (like your labor) is social capital, involving all sorts of things like a shared language, and trust that people will pay debts and deliver goods.

How does society lose these things? Several ways. Obviously, when your house burns down or gets sloshed away in a hurricane there’s a loss. When you eat the food, it’s gone. If you forget Mom’s pot roast recipe and it’s not written down, it’s a loss (well, my Mom’s, definitely). When photography becomes digital, a lot of the value of your fancy film camera is destroyed. And every day you don’t use your capacities to create value because you’re unemployed or your company forgot to order more of part 33962b-4, that’s a loss. But when someone steals your camera from your car, your loss is balanced by the gain to the thief. This doesn’t make it OK, and it’s just as sad for you, but it’s a fundamentally different kind of event from society’s perspective: a transfer, not a cost. [Update:The oversimplification in this example provoked Mark to reflections that are well worth a read.]

Continue reading “Sunk costs and recoverable costs: the bailout”

John McCain, financial idiot

And now, let us hold hands across the blogospheric divide.

My friend and colleague Steve Bainbridge is right: the President can, in fact, fire the SEC chair. What he can’t do is fire a commissioner, so he would have to choose a new chair from among the group of serving commissioners. The old chair would be just be a regular commissioner. According to the Securities Exchange Act of 1934 sec. 78(d), commissioners serve staggered five-year terms and one expires on June 5 of each year, meaning that the new President can replace one early in his term. I also wouldn’t be surprised if there was a culture of commissioners resigning (at least those of the same party) to allow the new President to put in his team.

That said, the real story is just how much of an economic moron/charlatan McCain is.

The gist of his argument is that the financial crisis is the result of the SEC allowing short selling. No one believes this. No one. There are a lot of reasons for the current crisis, and (unlike Steve) I’m not prepared without greater research to exonerate the SEC, but if McCain thinks that it’s about short selling, he even dumber than I thought.

But of course McCain doesn’t believe anything; he’s just saying anything to win. He doesn’t really know, and he doesn’t really care.

And that’s the story.