SPEAKING FREELY
Peak credit and a flight to simplicity
By Chris Cook
April 3, 2008
http://www.atimes.com/atimes/Global_Economy/JD03Dj04.html
Speaking Freely is an Asia Times Online feature that allows guest
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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.
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 sup****t this guarantee.
The problem has been that in recent years banks have been outsourcing
their guarantee to investors: permanently through securitization,
tem****arily 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 cor****ation). 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 sup****t 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 sup****t 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 cor****ations. Long-term investors, such as
pension funds, love these and it's not difficult to see why. They are
getting their hands on cor****ate 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 partner****p interests in
Blackstone revenues. Other rapidly growing asset cl***** 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 partner****p is essentially a new type of partner****p-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, *****sing
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.
Chris Cook is a former director of the International Petroleum
Exchange. He is now a strategic market consultant, entrepreneur and
commentator.
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