Peak Credit

A Flight to Simplicity

Chris Cook – BarCampBank London5th July 2008

What is a Bank anyway?

It is a “Credit Institution”

It creates Interest-bearing Credit (or “Debt”)

…which is >97% of the Money we use

Money created as interest-bearing loans……

…is immediately deposited into the system

A Bank is also a Credit Intermediary – or “Middleman”

BankBorrower Lender

£ £

….but what does a Bank really do?

A Bank guarantees borrowers’ credit…

......and charges “Interest” for their use of this Guarantee…

…deducts from that the Interest paid to Depositors…

…plus its operating costs and any defaults by borrowers..

…and aims to make a profit…

The Credit Pyramid

Bank Credit

Capital

Demand for Credit has been high…

….from property buyers and investors..

…from hedge funds and “Private Equity”..

….and Banks started to “outsource” their implicit Guarantee….

….“freeing up” and making best use of their Capital….

…totally – by “securitising” debt and selling it to investors….

…temporarily – using “Credit Derivatives”….

…and partially – using “Monoline” credit insurers

Result- a Bigger Credit Pyramid

Investor Capital

Credit

Bank Capital

…with Risk “Diced and Sliced”…

Investor Capital

Credit

Bank Capital

…so that no one knew where the risk lay…

What is Credit anyway?

?

Credit is an IOU and comes in two flavours…

….“Trade” Credit from a Seller to Buyer backed by Value….

….and Bank-created Credit supported by their Capital….

Credit is “Deficit-based” finance

….essential for the creation of productive assets……

….such as buildings, wind turbines, and software……

The problem comes when credit is created to buy existing assets……

….typically secured by a legal claim over the asset……

….resulting in “deficit-based” but “asset-backed” credit….

….such as loans secured against property (ie mortgages)….

….which are the source of over two thirds of dollars and sterling ever created…..

…and therefore of asset price “Bubbles”….

John Law created the first such Bubble in 1718

…and they have never stopped since…

…until last year we saw the culmination in the US of the “Mother of all Bubbles”….

…since when Banks have been asking themselves….

…is the risk with me?

….or with the hedge fund I dealt with?

…and they are thinking….

….if this is what OUR balance sheet looks like…..

…what does everyone else’s look like…..?

So Banks now charge more for their implicit guarantees…..

….and are much more discriminating in relation to counterparty risk…..

….based upon the Capital they have left…

….so that “wholesale” lending to other banks has all but dried up…..

…meanwhile investors have gone on strike

…so securitisation and credit derivatives have dried up too….

…while “monoline” credit insurers are also in deep trouble…….

…so no Capital there either…

The Result is that the pool of Capital supporting the credit pyramid….

…..has shrunk…..

Capital

Credit

…interest rates set by Central Banks are irrelevant….

….and credit is both in short supply….

….and increasingly expensive….

If Peak Credit is behind us….

…what lies ahead….?

I believe the answer is “Peer to Peer”…..

…direct connection….

…and ”dis-intermediation”….

What does “Peer to Peer” Credit look like?

Introducing the “Guarantee Society”

“Trade” credit is extended “peer to peer” when Seller gives Buyer “time to pay”….

…credit is subject to a mutual guarantee….

…through membership of a “community of interest”…….

…which may be geographic in scope…

…or functional, or both

Credit is interest-free, but not cost-free…

….since provisions are made into a “default fund”…

….and system costs shared…

….by both sellers and buyers, since all benefit…

….and with the sellers agreement….

….settlement may be in money or in “money’s worth”….

….such as units of energy or property rental value….

Banks no longer risk their capital….

…creating credit based upon it…..

….but manage “peer to peer” credit creation…

…as credit “service providers”

“Peer to Peer” Investment

“Equity” consists of “ownership” of property…

….“asset-based” rather than “deficit-based” finance

The kind of “Equity” finance Capital we are used to…

…is “stocks” or “shares” in a “Corporation”….

…the “Joint Stock Limited Liability Company”….

…which is what makes the “Private Sector” Private

But while we have all been looking the other way….

…at the financial revolution based upon credit innovation…

…there have been interesting developments “under the radar”….

…in “asset-based” finance.

In Canada we have seen “Income Trusts”….

….where part of the gross Corporate revenues are “unitised”….

….and sold to long term investors…

….such as pension funds....

…who love Income Trusts because…

…they are getting their hands on corporate revenues….

….before the management does….

…there are lots of other new ways to “invest” in assets…

…such as “Exchange Traded Funds”…

…“Real Estate Investment Trusts”…

…and not forgetting Islamic finance “Sukuks”

“You don’t know what you’ve got ‘til it’s gone”

…and you don’t know what you haven’t got ‘til you see it

…in 2001 the UK inadvertently made “the Corporation” redundant..

…when they introduced the UK Limited Liability Partnership (“LLP”)

An LLP can do anything a Corporation can do..

…own property; enter into contracts etc….

…and you can’t lose more than you put in..

….and.…errr….that’s it…..

…there need not even be an agreement in writing…

I call it an “Open Corporate”

….the US LLC is a close cousin…

…and both make possible a “Capital Partnership”

Introducing the Capital Partnership

Capital Partnership

Investors

Users

Revenues

Managers

% %

CustodianOwnership

….property is held by a “Custodian”..…

Capital Partnership

Investors

Users

Revenues

Managers

% %

CustodianOwnership

….and Investors put in money, or “money’s worth”

Capital Partnership

Investors

Users

Revenues

Managers

% %

CustodianOwnership

….which Managers use to fulfil the agreed purpose…

Capital Partnership

Investors

Users

Revenues

Managers

% %

CustodianOwnership

…and revenue or production is shared…

…..within a consensually agreed framework

The “Capital Partnership” enables new forms of Equity…

….proportional (%age) ”n’ths” such as billionths..

…..which may be bought and sold…

…but never redeemed…

…..because there must always be 100%

“Units”, such as kilowatt hours

….or barrels of oil

….or the use of an acre for a year

…which are redeemable..

…and with a value in exchange…

…but carry no rights to income…

These hold their value…

…because they are based on value..

… and not a claim over value..

….issued by a “Credit Institution”

So the possibility is there..….

…to affordably refinance housing debt…

…with simple new pools of land and property rentals…

…to keep assets in public ownership..

…but finance development by issuing non –redeemable “units” to investors…

….carrying a reasonable index-linked return

The result could be a National Equity…

…and a shrunken National Debt.

This is not Rocket Science…

….but it is a Flight to Simplicity…

….which, as it happens, is Islamically sound…..

When all is said and done

……maybe Ethical is Optimal?