By Dan Fox, on 10 June 2011
ISRS’s first foray into my chosen field of ‘Resilient Markets’ was a jointly presented seminar which took place on 6th June before an eclectic audience, including a former US central banker and a distinguished retired financier, but extending far beyond financial practitioners.
My co-host, Arthur Doohan, is a successful and radically innovative Irish banker. My background is of 25 years experience of market regulation and development, including six years as a director of a global energy exchange.
Our presentations, and the ensuing discussion, concerned two different approaches to resolution of unsustainable debt funding. The current position in the aftermath of property bubbles in affected countries, such as the US, UK, Ireland,and Spain in particular, is analogous to the aftermath of a bad accident.
The English Patient has had his visible wounds patched up and these are now healed. But he continues – undiagnosed – to bleed internally, resulting in the need for regular transfusions of credit (Quantitative Easing – QE) by the Bank of England. But at least – thanks to his QE – he’s walking about, albeit weakly and with dizzy spells.
The Irish Patient, on the other hand, was treated by doctors who stitched him up and then applied leeches, and is in a very bad way indeed.
Before even beginning to recover, the undiagnosed internal haemorrhaging of both patients must be stopped by Resolution of the debt: only then can the patients’ recovery begin through a transition to a sustainable financial system.
Arthur and I take different, but complementary, approaches to treating the patients.
Quantitative Resolution – Debt Offset
Arthur’s presentation covered his innovative proposal to galvanise the Resolution of Ireland’s disastrous and unsustainable legacy of property debt in the aftermath of what was perhaps the most egregious of all the national property bubbles.
In simple terms, he proposes to refinance and thereby resolve existing unsustainable debt. He proposes new issues of debt at (say) 50% of the face value of the original, now unsustainable, loans which are secured against properties now worth 50% of their peak value.
The outcome is that the distressed borrower would have a dramatically reduced mortgage loan at a new (lower) rate, while the investors in the new loans exchanged for the old would own matching deposits on the other side of the bank’s balance sheet at the prevailing (lower) deposit rate.
Since the bank’s original distressed loan is currently priced in the market at 50% of its original value, this proposal recognises that unpleasant reality and builds Resolution upon it.
So Arthur’s debt offset mechanism offers a simple and elegant way in which Resolution of an unsustainable debt burden may be made by reducing the quantity of obligations.
Qualitative Resolution – Unitisation
My approach is based not upon debt created and issued by banks and secured against property, but upon the simple but radical concept of the issue by property owners of undated credits – ‘Units’ – redeemable in payment for affordable and index-linked property rentals. Anyone who understands Air Miles, or Storecard points such as Tesco Clubcard points, will understand a Unit redeemable in payment for value.
Unitisation is, in effect, direct – ‘Peer to Peer’ – investment in property, with a return which derives from the market price of the Unit compared to the redemption value. eg a Unit with a face value of £1.00 issued at 80p offers a return of 25%, but the rate over time of that return depends upon the date of redemption.
The enabling mechanism for Unitisation is the use of one of an emerging generation of legal ownership frameworks which are not conventionally based upon Company or Trust Law, but upon associative agreements and partnership-based vehicles.
Instead of a loan by a bank to a land-owner, which is ‘asset-backed’ by a mortgage claim, Units comprise a loan by investors direct to the land. This ‘asset-based’ approach does not amend the quantity of obligations, but instead transforms the quality, so that the obligation to repay debt capital on specific dates disappears, along with compound interest.
This creates an interesting new calculus in respect of risk and reward.
Firstly, in terms of security, the risk for Unit investors in respect of their capital is not a credit risk – since their investment is not repayable on a specific date as debt is – but rather the risk that they cannot find a buyer: i.e. a liquidity risk. The risk that the Unit will not be honoured – through insufficient rental or otherwise – remains, however. Here it is the case that a rent set at an affordable level is, by definition, more likely to be paid; is thereby a lower risk; and therefore justifies a more modest rate of return.
Secondly, in terms of liquidity, instead of having numerous classes of debt fragmented by date, rate of interest and issuer; we have one single class of Unit in a rental pool created by multiple Unit issuers, with a common custodian. Moreover, if a financial investor is unwilling to buy Units, the price will fall to a level at which property occupiers will enter the market and buy Units for redemption.
There are certainly common elements to the proposals: there is the recognition that affordable payments are more likely to be made; and there is a similar symmetry between a right and an obligation, albeit Arthur’s model still has an intermediary bank between the two.
Where I principally differ from Arthur is in his view that the ‘London Model’ of property rights and investment is fundamentally a sound model. In my view, it is the London Model’s combination of compounding interest on debt, and absolute private property (particularly in land) which has led to periodic booms and busts for hundreds, if not thousands, of years, and to the current systemic imbalance in wealth and purchasing power which is frustrating all conventional economic remedies.
I believe that through what is essentially an exchange of unsustainable debt for a new form of equity, we may permanently resolve the existing funding problem, and prepare the way to a transition to a sustainable and resilient economy through a new approach to financing. But that, as they say, is another story, and for another seminar.