Lo@n, D*bt and Other Four-Letter Words

Prior to the mid-19th century, those who could not pay their debts were routinely tossed into prison.  Actually, you can still go to debtor’s prison in Germany, Greece, China and Dubai.  In the United States, two of the signatories to the Declaration of Independence (James Wilson and Robert Morris) were incarcerated for their unpaid debts.  In theory, the U.S. abolished such practices in the 1830s.  But six states still allow you to be arrested and detained indefinitely until you “work it out” with your creditors.

And while we humans seem to have a visceral negative reaction to welshers, our disdain for bad faith lenders goes deeper.  Condemnation of usury dates back to the Vedic texts in ancient India, and is condemned as well in all the other major religious texts in the world.  Islamic law (Sharia) prohibits the charging of interest at all, and considers the practice to be one of the seven heinous sins, right up there with murder and “unlawfully taking an orphan’s money.”

Lending is the most common form of investment and it comes in two basic varieties: unsecured (e.g. credit cards), and secured against some valuable asset (e.g. auto loans).

Unsecured Debt

The problem with unsecured loans is that there’s a misalignment of incentive between lender and debtor.  When you take out a student loan, the bank doesn’t expect you to be able to pay based on your earning potential at the time of the loan.  It expects you to invest the money into your education, thereby increasing your earning potential down the road.  That’s how it makes its profit.  While it may seem that you are aligned in this respect — you both want you to use the money to go to school and realize your potential — what happens if the job market is bad when you graduate?  The bank couldn’t care less.  Your obligation is the same, independent of your circumstances.  Your incentives have become misaligned.

Secured Debt

As we saw with the subprime mortgage meltdown, securing a loan against collateral does not work for either lender or debtor, if foreclosure is not an acceptable outcome.  The whole point of security is that it transfers the risk from the lender to the debtor, who after all, is the one in control of the secured asset.  Secured debt works best when the collateral itself becomes more valuable by virtue of the invested capital.

Let’s say you are a real estate developer whose expertise is in building homes.  There’s a plot of undeveloped land for $100K, and it will cost you $200K to build a house on it.  When you are finished you expect to be able to sell the house to a family of five for $400K, yielding a $100K profit.  You don’t have $300K so you go to an investor who loans you the money at 10% interest per year.  It takes you a year to build and sell the house, so you owe $330K to your investor, leaving you with a profit of $70K.

Notice here that everybody is better off in the world where that loan happened: you are able to apply your expertise to make a living even though you didn’t have the cash to pay for the land and construction cost; your investor is better off because instead of making 1% interest in a bank, they earn 10% interest; and the family who buys the house wins because now they have their dream home.  The loan is what has unlocked the creation of new value that is shared between you, your investor and the family.

But what would happen if it took you three years to construct and sell the property?  Now all of a sudden your loan payoff amount is $400K and you’ve lost money on the investment, once you consider your time and the income you’ve foregone during those three years.  Or what if you got sick during the construction process, couldn’t work on the house anymore and your investor was forced to foreclose on a partly-completed house?  Not only have you lost, but so has the investor, who may not be able to sell the property until it’s completed, and certainly would not earn the full potential value of their 10% interest investment if they couldn’t finish it themselves.  And of course the family loses because they don’t get their dream home.

As with unsecured debt, a collateralized loan can easily go from value-creating investment vehicle to an inflexible straightjacket which binds everybody into a losing outcome.

“Freedom’s Just Another Word for…”

Indenture, according to Wikipedia, is “a legal contract reflecting a debt”.  As I reflect this Independence Day on the theme of independence in an interdependent world, I can’t help but wonder why we Americans have such a predilection for indenturing one another.  Make no mistake — the global financial crisis is not due to lack of productivity, nor is it a crisis of faith.  We would not be in this mess were it not for our addiction to making and receiving loans.

At the global level, the birthplace of democracy is teetering on the brink of insolvency itself due to its overextended sovereign debt.  And as a testament to just how interdependent we are, the world is about to make a lending offer to Greece that it can’t refuse, nor could the world afford to withhold.

Debtor’s prison may be a possibility for Greece’s citizens still, but it is all of us who are mortgaging away our freedoms if we do not break our addiction to d*bt.

  • Anonymous

    I just wanted you to know that I highly admire you and what you do, particularly with regard to “Angel investment”. You owe absolutely nothing to anyone in the world and would be well within your rights to keep your wealth of resources and experience to yourself, and you don’t. If the world had more people like you, the entire planet could be elevated to a much higher level. Had I your resources, I’d want to do the same thing. So please don’t stop – humanity needs your kind now more than ever. A tip of my hat to you, sir. :-)

    As for the scientific method, I wholeheartedly agree. A year or so ago, I came up with the concept of “Reinvention science”, a scientific method whereby you start trying to develop technology totally from scratch, but you can’t use any processes which are currently widespread and common – or any of their predecessors. For instance, you can’t make fire by rubbing two sticks together or cracking stones against one another, or you must find something that serves the function of a wheel without being one (an upside-down trackball, perhaps). Things of that nature.

  • Rafe Furst

    Thanks, Solomon.  And I like your “Reinvention Science” methodology!

  • Pingback: Revenue Sharing - The Emergent Fool()