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Peak Credit - my Op Ed in Asia Times

by ChrisCook Thu Apr 10th, 2008 at 03:32:03 AM EST

Well, "Asia Times Online" have just published my article

Peak Credit and a Flight to Simplicity

and for those of you who are dazzled by the flashing ads on that site the text follows.

Peak Oil - the theory that we may be at or near a peak level of oil production - while remaining controversial is at least now respectable. But is the continuing credit crash masking another inconvenient truth? Might banks now be experiencing the aftermath of peak credit?

What is a bank anyway? They are actually credit institutions. They create the credit - as interest-bearing loans - which constitutes the life blood of the economy. This credit actually is the bulk (or more than 97%) of the money in use in the US, the rest being notes and coin.

Banks stand between borrowers and depositors: they extend credit to borrowers and receive credit from depositors. So they are also middlemen or credit intermediaries.

Promoted by Migeru


[editor's note, by Migeru] Fold inserted here for the front page
But let's stand back for a moment and consider the actual economic function of a bank ... in fact what it actually does is provide a guarantee to its depositors that its borrowers' credit is good. The interest charge the bank makes for doing this has to cover the interest it pays to depositors, operating costs and default costs, and will normally produce a net profit.

If you think about it, trade credit from seller to buyer costs nothing to create, and of course bank credit costs nothing to create either: so it is the implicit bank guarantees that represent the economic value they provide. Regulators - overseen by the Basel-based Bank of International Settlements - specify and monitor the amounts of regulatory capital which must be held to support this guarantee.

The problem has been that in recent years banks have been outsourcing their guarantee to investors: permanently through securitization, temporarily through credit derivatives, and partially through insurance, by monoline (ie with a single line of business) credit insurers, such as Ambac.

By using investors' capital to augment their own, a much greater pool of credit has been created than banks could ever have sustained on the basis of their own resources. Unfortunately, this has been done in such an opaque way that no one actually knows who is at risk. The market in such investments has now frozen as investors have gone on strike, probably permanently.

Asset-based and deficit-based finance
Credit is essentially an IOU and is very different from equity (for example, shares in a corporation). We can think of credit as deficit-based finance, and equity as asset-based .

Problems arise when deficit-based credit is created and used to buy pre-existing assets rather than to create new assets. This almost invariably leads to asset price bubbles, the first of which was John Law's Mississippi Bubble in France in 1718. A bubble begins when asset prices lose touch with any revenues generated by the assets and continues to inflate until no further borrowing is available. Asset prices then collapse in a wave of defaults, which ruin borrowers and sometimes the banks.

In the US, this guarantee outsourcing led to a pyramid of cheap credit and caused - among other things - the mother of all bubbles in US property prices.

Looking back on it now, it seems clear that the peak of the US property bubble may actually have been peak credit.

What now?
New capital is needed to support the creation of new credit, but the process of rebuilding bank balance sheets cannot even begin until it is clear that the property bubble has deflated. The investors in outsourced guarantees are long gone, and we are already seeing the specter of a credit famine stalking the land.

Perhaps the Internet will ride to the rescue? The pervasive spread of the Internet is increasingly connecting individuals directly peer to peer. The revolutionary Napster music-sharing service mapped the route to the creation of peer to peer lending sites such as www.zopa.com and www.prosper.com. Perhaps banks as credit intermediaries are no longer necessary, and will morph into a future as service providers?

One possibility is for a central bank to create and issue credit directly to borrowers, who could then pay interest into default funds. These pools would support a guarantee backed by governments.

In fact, why should not the Treasuries issue credits directly? Hong Kong has been hugely successful without a central bank, but with a Monetary Authority supervising conventional bank credit creation.

In a dis-intermediated model, banks need no longer put any capital at risk by creating credit based upon it, but would instead manage the creation of credit. So they would operate as a service provider setting guarantee limits, handle defaults and administer systems, all under the stern but benevolent gaze of a monetary authority.

These risk-sharing pools would enable the creation of the unsecured credit that finances development and economic growth. Now, this is all very well for financing the creation of productive assets, but if used to acquire existing assets may still cause asset bubbles. This is where a new form of asset-based financing comes in - unitization.

All eyes have been on the world of credit, and the spectacular returns possible through the gearing which causes bubbles. In the meantime, however, there is a quiet revolution going on under the radar in asset-based finance.

Perhaps the best-known examples have been income trusts and royalty trusts, still commonplace in Canada and very popular in Australia until the tax treatment changed. These unitize rights to part of the gross revenues of listed corporations. Long-term investors, such as pension funds, love these and it's not difficult to see why. They are getting their hands on corporate revenues before the management does: would you rather drink the water before it goes into the bath, or after it comes out of the plug-hole?

Similarly, the recent Blackstone initial public offering in the US was not a sale of conventional shares but of partnership interests in Blackstone revenues. Other rapidly growing asset classes are exchange traded funds (ETFs); real estate investment funds (REITs) and Islamic Sukuks - all asset-based.

Reversing the polarity
There is an urgent need for the refinancing of literally trillions of dollars worth of property-backed securities and debt. My proposal is to achieve this through the creation of a new generation of asset-based property finance.

A capital partnership is essentially a new type of partnership-based evergreen leasing framework. Property freeholds are held within the framework by a custodian with property occupiers and financiers as co-owners, as follows: Occupiers pay a capital rental for the use of the property. An affordable, but index-linked, rental is then set. Units in pools of property rentals are then sold to long-term investors. Any rental paid by the occupier before due date automatically becomes investment. When an occupier's income as an investor equals the rental due for the use of the property he is - in economic terms - the owner.

The result is property finance which is affordable since: occupiers pay to maintain the property but are not repaying a loan; an index-linked return may be set at a lower rate than a conventional return. For investors, the affordability of the finance means their return is much more certain.

There is an ocean of money seeking secure real returns. What better way than to invest directly in units of affordable property rentals? Through a debt/equity swap the enormous overhang of property backed credit slowly strangling global financial system could be refinanced.

Banks would again be operating in a service provider role, assessing investments, bringing investors together with investments, and providing necessary liquidity, ie investment banking.

I believe we have indeed seen peak credit. The unitization of property rentals could not only avert the looming crisis in the US but conceivably even give rise to national equities alongside shrunken national debts. Hong Kong is perhaps better placed than anywhere else to achieve this, being half way there already in both financial architecture and tenure.

by Chris Cook

2nd April 2008

I think that, like "Peak Oil", Peak Credit is a "meme" that might spread, and I am hoping that the use of language such as "asset-based" to distinguish from "deficit-based" is another potential of the possibility of "re-framing" the debate.

I've also started to distill the article down into a narrative suitable for presentations, and this has already had the effect of opening a few eyes to the actual reality of the current system which is not only hidden behind "smoke and mirrors" but is regarded by the mainstream media as akin to "Financial Pornography".

I believe that it is not only possible but absolutely necessary for the Planet's survival, that the "Polarity" of the world's financial system should reverse,from a "deficit basis" to an "asset basis" and that this process has in fact already begun.

 

Display:
The Asia Times editor has obviouly been reading CCook diaries and comments on a regular basis ;-)

I believe you are absolutely right, and that this process of change that has begun will lead to greater happiness and greater dignity, and hopefully restore the respect for self, others, ecosystems and the rock skinned ball that we all sit on.


You can't be me, I'm taken

by Sven Triloqvist on Wed Apr 2nd, 2008 at 10:09:52 AM EST
Welll, Asia Times have published several of my articles in recent times, and while I'm not up there with Henry Liu, I am on their list of "usual suspects".

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Thu Apr 3rd, 2008 at 10:43:55 AM EST
[ Parent ]
well I think congratulations are in order!

good on you!

by zoe on Thu Apr 10th, 2008 at 05:47:54 AM EST
[ Parent ]
Seems very plausible but would appreciate you giving an example of the solution. Examplwe should have cost of property, investors' return, rental amount, how rentor becomes owner and what is the long term return? One of the questions is how does the rentor cover the cost of the property plus a reasonable return to the investor if the payment required is excessive relative to his income? Arent you describing 100% financing with the only differwence being the investor would accept a minimal return in exchange for an equity position in the property? An example would make it more understandable.
by An American in London on Thu Apr 3rd, 2008 at 04:43:54 AM EST
The starting point is always the question: what can an Occupier of land and property afford to pay?

And then: where does he/she get that from?

And then: how can we restructure and unitise the flows that result?

One of the key points to understand in the model is that  Property (as an object) is never sold again, remaining nominally in the hands of a Custodian.

I am sure you will know that this is exactly how conventional institutional share trading (for instance) works now.

What happens instead is that the bundle of rights and obligations is divided between financier and user of finance in a simple but radical new way.

So the Occupier may change - and rent somewhere else.

The Financier may sell his "nth's" or "Units" to another Investor (probably Occupiers).

A "Manager/Operator" may also change.

But the freehold stays in Custody.

Some would say that's not a million miles away from the current position with the Queen as "Custodian" of all freeholds.

Anyway.

We set an "affordable" "Capital Rental" (questions of subsidy and alternatives to taxation may be addressed through Community "Location Rentals").

Say that gives us an initial flow of £100k in the first year relating to a pool of properties.

First, we index link it.

Then we simply divide the resulting index linked revenue stream into "n'ths" .

If these are (say) "thousandth's" each of them carries the right to £100.00 in the first year, rising with inflation thereafter, and backed by "ownership" of one thousandth of the relevant assets.

Now it's simply a question of the price of such a "thousandth" unit. And of course a "thousandth" of this pool is a "millionth" of a "Pool of a thousand Pools".

If we sell them for £4,000 they have an initial return of  2.5%. and we raise £4m

If we sell them for £2,000 that's an initial return of 5% and we can raise only £2m.

There's a big market out there for index-linked assets, for sure. Its "asset-basis" is also relevant to Islamic Finance if it's structured correctly.

Of course, the more "affordable" it is (especially if government backed) then the more certain it is that it will be paid.

If you are interested in finding out more, drop me an email. I'm working on practical real world examples.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Apr 3rd, 2008 at 07:54:59 AM EST
[ Parent ]
What's the current tax situation on this?

You said in the article that income=rent is equivalent to ownership.

If you have to own sufficient "units" to pay the rental from income after tax, then, assuming a marginal tax rate of 30% (roughly that of those who pay basic rate tax and NI)

£100,000 property, 5% capital rent = £5,000 pa

£5,000 grossed up = £7143

Investment required to live "rent-free" in a £100,000 property = £142,857

by Sassafras on Thu Apr 10th, 2008 at 01:11:16 PM EST
[ Parent ]
Oops.  Of course there'd be no NI on investment income.  But the principle of having to invest more than the house is worth remains the same.
by Sassafras on Thu Apr 10th, 2008 at 01:13:56 PM EST
[ Parent ]
Tax is always a key issue of course, and we have to look at this model in the context of a rational and holistic approach to taxation and pensions policy.

This government is falling over itself for people to "get on the property ladder". But all the government does do is bid up land prices further.

This approach essentially takes the land out of the equation (properties are never bought or sold again) and opens up new policy options (which I have not outlined in the article for the sake of simplicity) for the relationship between the community/municipality and the individual.

Firstly, is it in fact "income" or a "capital gain"? One could probably configure "Equity Shares" to be the latter, and few indeed use up their capital gains allowance each year.

Secondly, when the LLP was legislated in 2001 the government specifically prevented pension tax relief on "Property Investment LLP's" so it is not currently feasible either for institutional or personal investment (in a SIPP, say).

But I would bet that this will change soon enough if UK investors see foreign pension investors accessing tasty UK asset classes which they cannot.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Apr 10th, 2008 at 03:41:01 PM EST
[ Parent ]
Tax is always a key issue of course, and we have to look at this model in the context of a rational and holistic approach to taxation and pensions policy.

Isn't that another way of saying that this will work just fine as long as the current taxation system is redesigned around it?

I cannot imagine that the Revenue is going to lie down and accept an index-linked rental income as equity without a fight.

If normal taxation on investment rules apply, that would make the investment required to live rent free in a £100,000 apartment (for a 20% taxpayer) £125,000.  And, for a 40% taxpayer, £166,667.  Assuming zero management charges.

I wish you luck, but I hope you have some very good tax lawyers, and sufficient case law to obtain an insurance-backed indemnity for your occupier-investors.

by Sassafras on Thu Apr 10th, 2008 at 06:02:00 PM EST
[ Parent ]
Hmmm...I think there is some confusion here.

As I see it, the situation is precisely the same as applies with an offset mortgage. As far as I know, if an individual pays off part of his mortgage loan temporarily with "savings" which he may then draw down upon, he does not get taxed on an imputed amount of loan interest he is thereby not paying.

The same applies here. The Occupier may acquire "Equity Shares" (ie proportional shares in the land/property rental values) at a market price by paying more "Capital Rental" than is due.

He does this through membership of a "Land Partnership" property pool which is essentially a Cooperative of Property Occupiers in partnership with a Cooperative of Property Investors where the freeholds are all held by a "Custodian".

These "Equity Shares" confer no taxable income, as far as I can see, but do reduce the Capital Rental due.

The partnership framework essentially allows a new form of hybrid tenure of indefinite duration or "evergreen" lease.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Apr 10th, 2008 at 07:05:24 PM EST
[ Parent ]
It's not quite as simple as that, though, is it?  Because you'll be asking the Revenue to accept that the same unit can be the equivalent of a a guaranteed income share in the hands of one taxpayer, but ceases to be taxable when that same unit is transferred to another.  But the proof of the pudding is: have you got Revenue approval for the scheme?

The other thing that occurs is: what would happen regarding the principal private residence tax exemption if home "ownership" is through shares in a cooperative?

Assume I bought my occupier-investor units for £100,000 ten years ago.  They're now worth £200,000, and I want to sell.  Would it be tax free, as it would be if I'd bought my home outright?

by Sassafras on Fri Apr 11th, 2008 at 04:23:11 PM EST
[ Parent ]
Sassafras:
Because you'll be asking the Revenue to accept that the same unit can be the equivalent of a a guaranteed income share in the hands of one taxpayer, but ceases to be taxable when that same unit is transferred to another.

I don't think so. The "interior" of an LLP structured as a framework in this way is a very interesting zone, because what we are seeing is essentially transfers between partners.

This is not a million miles away from the sort of internal transfers that go on within a multinational but not with the same end in view of tax avoidance.

It is the "Occupier" members who are the origin of any income of any other pure "Investor" members. The income of one member of the partnership is essentially coming from another member's use of the capital within the partnership.

The income received by non-Occupier members is to all intents and purposes similar to interest from deposits with building societies.

The difference is that this income is not in fact "guaranteed": if there is no Occupier, there is no income, which is an "Equity" risk.

I don't see how the Revenue could say that an Occupier is in receipt of any income for as long he is in Occupation and his Equity in the Pool does not exceed 100% of his rental obligation. ie for as long as he is making net payments to Investors.

The taxman gets his hands on the income non-Occupier investor members receive for the use of their capital.

As he should.

Proof of the pudding is in the eating of course, as you say, and we wouldn't dream of going "public" with such schemes until we have talked it through officially with the Revenue. This is very much a process under development and any input from experts like yourself is extremely valuable.

Sassafras:

Assume I bought my occupier-investor units for £100,000 ten years ago.  They're now worth £200,000, and I want to sell.  Would it be tax free, as it would be if I'd bought my home outright?

As things stand probably not, because it's not "your" residence although you do have the exclusive and indefinite right of occupation for as long as you pay the Capital Rental.  But it wouldn't be too difficult to "bed and breakfast" each year, I guess, if that were advantageous.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Fri Apr 11th, 2008 at 06:29:26 PM EST
[ Parent ]
Assume that the occupier pays the market rent and the total price of the shares equals the market sale price of the property. That gives you the rate of return on investment, not counting maintenance costs. Any attempt to exceed that rate of return is doomed in the long term.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris
by Carrie (migeru at eurotrib dot com) on Thu Apr 3rd, 2008 at 08:54:20 AM EST
[ Parent ]
Now the "market rent": and its relationship between the "Capital Rental", the "Maintenance" and the "Location Rental" (which is essentially the free ride property owners get from public expenditure on infrastructure) is where it gets interesting.

I reckon I've cracked it, and have a practical solution which would work.

And that's just the sort of project I'm working on up here in Scotland...

In fact the deadline on one (300 property) bid was two hours ago.

Fingers crossed....(it's just the start mind you)

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Apr 3rd, 2008 at 09:01:07 AM EST
[ Parent ]
Yes, but a more low-brow approach would be just to saunter over to the nearest real estate agent and ask...

For instance, the other day I saw an ad for a property with an asking price of GBP540k which claimed a yearly rental income of GBP37k (the building comprised several lodgings and commercial premises). The return rate there is 6.9%. If you tax income at the marginal rate (40%) you get a 4.1% return rate after tax. This doesn't include council tax or maintenance, but those would be added to the rent and would not accrue to the investors so they net out.

The point is that trying to extract more than, say, 5% nominal after-tax returns from property is simply not realistic. What? That's not enough for investors? Then that will depress the property price until the ratio is as they desire.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris

by Carrie (migeru at eurotrib dot com) on Thu Apr 3rd, 2008 at 09:33:44 AM EST
[ Parent ]
Well, one of the interesting effects is that the model eliminates a lot of transaction costs, including stamp duty on sales (cos there wouldn't be any sales).

What would happen is that stamp duty would apply on purchase and sale of "Units" as on conventional shares, I think.

There are two roles for current intermediaries. An estate agent brings Occupiers together with properties, and financial service providers bring Investors in property pools together with investments, make markets etc

Btw I don't think people realise how regressive UK Stamp Duty is for the average Joe Blows with chunky mortgage loans.

If you consider the amount of actual "Equity" people have in their homes the application of Stamp Duty to the gross sale price gives rise to outrageous rates of taxation applying down the average "chain", in comparison to the net proceeds which flow, particularly in the lower levels of the market where people are struggling "up the ladder" into second or third homes etc

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Apr 3rd, 2008 at 10:31:32 AM EST
[ Parent ]
Brilliant. Nuf said.

A pleasure

I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude

by kcurie on Fri Apr 4th, 2008 at 03:44:40 AM EST
"By using investors' capital to augment their own, a much greater pool of credit has been created than banks could ever have sustained on the basis of their own resources. Unfortunately, this has been done in such an opaque way that no one actually knows who is at risk. The market in such investments has now frozen as investors have gone on strike, probably permanently."

By allowing securitization of NINJA loans, and other "sub-prime" mortgage products the US Federal Reserve Bank has injected a perhaps lethal dose of poison into the circulatory system of the international financial system.

It may be that changing real estate finance from a "deficit basis" to an "asset basis" would provide a path forward.  But the primary problem remains how to police the system, (perhaps Greenspan thought the invisible hand would perform that function), and how to prevent gross abuses during the transition between systems, as in Russia during the '90s.  Should the current financial problems be as serious as some fear, it is unlikely there will be much time to work out details.

A significant amount of wealth is in the form of unmortgaged property, CDs and money market funds belonging to retirees. How could this proposed system mediate between the interests of this population and the needs of the larger economy.  I would bet that a large portion of this population would think that a 5% return, combined with genuine security insulated against currency risk would be an acceptable bargain. This population also has a high propensity to vote.  

 

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Apr 10th, 2008 at 07:51:11 PM EST
ARGeezer:
I would bet that a large portion of this population would think that a 5% return, combined with genuine security insulated against currency risk would be an acceptable bargain.

That 5% return is before inflation. The "Affordable Rentals" which form the basis of the new form of "Equity" I advocate would be index-linked, and therefore the rate would be less, maybe 2 to 3% pa.

Moreover one of the most interesting features of the model is that it is superior to either of the two principal "Equity Release" mechanisms:

(a) "Reversion" - where someone pays an Equity Share in your house and gambles on how long you live - so if you are 85 you get more than if you are 65;

(b) "Roll Up" mortgages - where interest is not paid, but "rolls up" at a pretty high rate.

A home owner simply sells "Equity Shares" to investors and pays a "Capital Rental" in respect of them either in cash - thereby maintaining his level of Equity - or in more Equity Shares.

This mechanism runs down Equity more slowly than any other.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Apr 10th, 2008 at 08:10:24 PM EST
[ Parent ]


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