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 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
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
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
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
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
(Copyright 2008 Chris Cook.)
Chris Cook is a former director of
the International Petroleum Exchange. He is now a strategic
market consultant, entrepreneur and commentator.
This article was published on 3rd April
2008 in Speaking Freely, an Asia Times online magazine:
Credit and the Fight to Simplicity"
Chris Cook - 5/72008 - Power Point Presentation
at Bar Camp Bank: "Peak
Chris Cook - 2008: "Peak
Credit -The Aftermath" - the UK Approach
Chris Cook - 2008: "Peak
Credit - Bear-Faced Robbery - the US Approach