In dealing with the Soviet Union, Ronald Reagan had a favorite saying: trust, but verify. It was something the Russians understood innately, because as it turns out, when he said it, Reagan was quoting Felix Edmundovich Dzerzhinsky, one of the architects of the Soviet secret police.

Although Dzerzhinsky and Reagan used it in the context of politics, the concept has strong roots in business. There, it’s called due diligence. Just as with the U.S. and the U.S.S.R. in the old days, both sides in a business transaction have strong motivation to accept the word of the other. Common sense, however, dictates one take steps not only to confirm what you hear but to consider its validity.

I find myself thinking about trust and due diligence a lot these days. When I was watching U.S. senators questioning Goldman Sachs on CNBC recently, I was struck by how little seemingly rational and intelligent people relied too much on the first and too little on the second. The topic of discussion was stated-income loans — loans given based not on documentation, but on the borrowers’ word. Borrowers stated their income, and the figure was accepted.

The use of stated income began logically enough. It was used with high-net-worth individuals, people so well-entrenched that their companies paid most of their expenses. They really had no income per se; there was no need of it. But these people clearly had other assets, assets whose existence could be verified.

The meltdown that we just witnessed came when the banking industry realized that it could charge more money for loans with additional risk. So they adapted stated-income loans for a much larger pool of people for whom it was intended. Fold in derivatives, in which the risk was supposedly shared, and you have institutions buying into loan pools, thinking 1) that someone had performed due diligence on the original set of loans and 2) that real estate values were only going to go up.

Too much trust, not enough diligence, and a trillion dollars of value went poof.

As I’ve written about previously, in putting people who have never been homeowners before into distressed properties, I’ve had to reconfigure my thoughts about trust and due diligence. Trust has three components: sincerity, reliability, and confidence. If I can’t judge a buyer by their credit history (because they don’t have one), I have to come up with new ways to judge them. How much money is in their bank account? How much does what they say align with what I see and hear? How fast do they get back to me with information?

Interestingly, it has paid off financially. We had originally planned to sell properties in exchange for notes, and then sell the notes to regenerate cash flow. We initially planned to sell them in the first six months after the transaction, but because the risk is higher, we get less money; say, 60-70% of the note’s value. After a year, the discount goes way down to about 25 or 30%, because people have demonstrated that they can make their payments on time. More confidence, less risk, more value for us. It’s built-in evidence of due diligence.

It’s working great for DBNR. I wish the bigger financial companies were as committed to it as we are.

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