Equity Shares A Debt Free Solution to the Property Crash Chris Cook FEASTA Annual Lecture 2008 5 November 2008

We live in Interesting Times….. 06/06/09

… .some say, “the end of the financial system as we know it” 06/06/09

Most people have now heard of Peak Oil.... 06/06/09

… .but last year we reached the point of Peak Credit.... 06/06/09

...when the Irresistible Force of economic growth…. 06/06/09

...met the Immovable Object of finite resources... 06/06/09

...and Peak Oil 06/06/09

Where did it all go wrong? 06/06/09

To find out, we need to understand what banks actually do.... 06/06/09

A Bank is a Credit Institution which creates credit as interest-bearing loans.... 06/06/09

... a Pyramid of Credit, on a base of “Regulatory Capital”... Bank Credit Bank Equity 06/06/09

...and this Credit constitutes >97% of the money we use.... £ 06/06/09

..but a Bank does not lend pre-existing money…. 06/06/09

… .it creates new money as interest–bearing credit…. 06/06/09

… .which is then deposited back into the system 06/06/09

But a Bank’s true economic function…. 06/06/09

...is as a Credit intermediary or middleman... Lender £ 06/06/09 Borrower

...stepping between borrower and lender... Bank Lender ( Depositor ) £ £ 06/06/09 Borrower

… and guaranteeing that the borrowers’ credit is good… 06/06/09

Interest is charged for the use of the guarantee Bank Interest Borrowers 06/06/09

..from which Interest is paid to Depositors.. Bank Interest Borrowers Depositors Interest 06/06/09

..Default and Operating costs deducted... Bank Interest Borrowers Depositors Interest Costs 06/06/09

..and a profit to Investors normally results Bank Interest Borrowers Depositors Interest Costs Investors 06/06/09

Demand for Credit has been so high… 06/06/09

… .that Banks began to “outsource” their guarantee to rid themselves of risk. 06/06/09

… and thus allow Equity to support more credit creation 06/06/09

Banks outsourced risk totally – through “securitising” debt and sale to investors…. 06/06/09

… temporarily – with “Credit Derivatives” (a time-limited guarantee)…. 06/06/09

… and partially – using credit insurance from insurers such as AIG 06/06/09

The Result is a bigger Credit Pyramid than Banks alone could sustain… Investor Equity Credit Bank Equity 06/06/09

… and a “shadow banking system” of Investors with “sliced and diced” risk… Investor Equity Credit Bank Equity 06/06/09

This extended Pyramid of Credit funded the “Mother of all Bubbles” in US property prices…. 06/06/09

… and servicing this credit finally exceeded the financial capacity of the US population... 06/06/09

… to the point of Peak Credit .... 06/06/09

In August 2007, the Bubble started to deflate and attention turned at last to defaults … 06/06/09

..but by now no-one knew where the Risk lay… Investor Equity Credit Bank Equity 06/06/09

Banks started to think, “if this is what our balance sheet looks like…..” 06/06/09

“… what does everyone else’s look like…..?” 06/06/09

...and Banks stopped lending to each other ... 06/06/09

The problem is not shortage of money - liquidity – Central Banks can handle that 06/06/09

… ..it is shortage of Equity - Solvency – which Central Banks cannot handle….. 06/06/09

Bank Equity is being eaten away by defaults…. 06/06/09

… and Investors will not recapitalise the shadow banking system... 06/06/09

The Result? Equity Credit 06/06/09

So, Credit is becoming both scarce and expensive…. 06/06/09

… Central Banks are irrelevant…. 06/06/09

… and further defaults in the shadow banking system….. 06/06/09

… .continue to drain money out of the system in a “deflationary spiral”.... 06/06/09

… .leading inevitably to a Depression.... 06/06/09

So much for the Credit Crunch problem 06/06/09

Clearly the solution cannot lie in creating more credit 06/06/09

So why not take a new approach to “Equity” investment instead? 06/06/09

Conventional Equity consists of shares in a Limited Company or “Corporation”…. 06/06/09

Ownership by a Corporation is what makes the “Private Sector” Private 06/06/09

While the Corporation may be conventional, it is not the only enterprise model there is 06/06/09

While all eyes have been on Credit innovation… 06/06/09

…” Asset-based” finance has been developing “under the radar”…. 06/06/09

Canadian “Income Trusts” use a Trust law framework to “unitise” gross Corporate revenues…. 06/06/09

Income Trust Income Trust Corporation Gross Revenues Unit Investors % % Units Costs Dividends? 06/06/09

Units are sold to risk averse investors such as pension funds… 06/06/09

… who consider investment less risky if they access corporate revenues… 06/06/09

… . before the management does…. 06/06/09

We are also seeing new asset classes such as Exchange Traded Funds (“ETF’s”)…. 06/06/09

… Real Estate Investment Trusts (“REIT’s”)… 06/06/09

… Hedge Funds using Limited Partnerships… 06/06/09

… and Islamic finance ”Sukuks” 06/06/09

In 2001 the UK introduced the Limited Liability Partnership (“LLP”)...... 06/06/09

....confusingly, an LLP is not legally a partnership... 06/06/09

… but a corporate entity with a legal personality independent of its members..... 06/06/09

… and limited liability, so members cannot lose more than they put in..... 06/06/09

… and...errr...that’s it ...there isn’t even a requirement for a written LLP agreement... 06/06/09

… which is why I call it an “Open” Corporate.. 06/06/09

… and it is being put to some very interesting uses... 06/06/09

Capital Partnership - Hilton Deal 2002 Capital Partnership LLP 10 UK Hotels Gross Revenues Hilton Group Capital User Consortium LLP Capital Provider Bank Property Developer Hotel Specialist % % % % % 06/06/09

The Hilton Deal was the first example I have seen of a “Capital Partnership”... 06/06/09

...which I believe may perhaps be an optimal enterprise model - as follows.. 06/06/09

Firstly, ownership of productive assets is transferred to a “Custodian”.... Assets Custodian Ownership 06/06/09

… then Investors put in Financial Capital in money, or “money’s worth”… 06/06/09 Assets Investors Custodian Ownership Financial Capital

… Managers put in Human Capital of time, expertise and experience.... Assets Investors Managers Custodian Ownership Human Capital Financial Capital 06/06/09

… and Users pay for the use of this Capital… Assets Investors Users Payment Managers % % Custodian Use 06/06/09

… resulting in a “Capital Partnership” Assets Investors Users Managers Custodian 06/06/09

A “Capital Partnership” enables new forms of Equity… 06/06/09

(a) Equity Shares - proportional (%age) ”n’ths” such as billionths..... 06/06/09

… ..which may be bought and sold, but never redeemed, because there must always be 100% 06/06/09

(b) Redeemable Units – eg Kilo Watt Hours; 06/06/09

...with a value in exchange, but with no continuing rights to production 06/06/09

Units hold their value because they are asset-based on value provided by the issuer … 06/06/09

… .rather than being deficit-based upon a claim over value issued by a Bank 06/06/09

€ nergy investment is for another time... 06/06/09

..today we are looking at the potential of Land Partnerships.... 06/06/09

...to solve the current Credit Crash. 06/06/09

Imagine a developer has unsold homes.... 06/06/09

....and a Bank on his tail .... 06/06/09

...who in turn has a Central Bank on their tail.... 06/06/09

First, we transfer the houses to a Custodian Houses Custodian 06/06/09

Then we rent the houses affordably but at an index-linked rental.... Houses Occupiers Custodian Rental 06/06/09

....noting that because rents are affordable, failure to pay is by definition unlikely... 06/06/09

Then we appoint a Manager and give him a proportional share in the rentals.... Houses Occupiers Custodian % Rental 06/06/09 Manager

....so that with a stake in the outcome he has an interest in doing a good job... 06/06/09

....and the Investors complete the picture Houses Investors Occupiers Custodian % % Rental 06/06/09 Managers

Occupiers may “Rent to Buy” - simply by paying rent early, they become Investors... 06/06/09

...and end mortgage slavery as rental may then be paid in Equity Shares, not cash... 06/06/09

...while maintaining the property themselves will give them “Sweat Equity”.... 06/06/09

For Investors it’s an index-linked, property-based investment... 06/06/09

..with low risk, since affordability=certainty.. 06/06/09

...giving a perfect match for the liabilities of the pension funds... 06/06/09

...who will buy from distressed developers their Equity Shares in the Rental Pool.... 06/06/09

...so that they can repay distressed Banks... 06/06/09

...and make the Central Bank happy 06/06/09

Lets have a quick look at the numbers 06/06/09

Imagine a Pool of a thousand homes with outstanding debt of €200 million Conventional Mortgage Finance 25 year loan at 6% gives repayments of €15,600 pa per home and €15.6m pa in total 06/06/09

Conventional Mortgage Finance

25 year loan at 6% gives repayments of €15,600 pa per home and €15.6m pa in total

Imagine a Pool of 1,000 homes with outstanding debt of €200 million Land Partnership Step 1 - Create the Pool Set an affordable rent (say) €6000 in the first year Rental Pool is then €6m in the first year Step 2 – Unitise One million Equity Shares each with the right to €6 initially Step 3 – Sell Equity Shares to Investors @ 3% initially €200 million is raised– repaying all debt @ 4% we raise €150m – and repay 75% of debt And so on 06/06/09

Land Partnership

Step 1 - Create the Pool

Set an affordable rent (say) €6000 in the first year

Rental Pool is then €6m in the first year

Step 2 – Unitise

One million Equity Shares each with the right to €6 initially

Step 3 – Sell Equity Shares to Investors

@ 3% initially €200 million is raised– repaying all debt

@ 4% we raise €150m – and repay 75% of debt

And so on

Let’s have a look at undeveloped land... 06/06/09

Conventional development is based on transactions – the “Four B’s”..... 06/06/09

Borrow, Buy, Build and B...er Off... 06/06/09

First, the land is transferred to a Custodian Land Custodian 06/06/09

...and the Land Owner becomes an Investor Land Land Owner Custodian Land Value 06/06/09

...as does the Council, in return for planning permission... Land Council Custodian Value of Planning permission 06/06/09

...and so do the Contractors at least for their profit margin... Land Contractors Custodian Profit Margin 06/06/09

...and Risk-Takers provide € to pay Contractors’ agreed costs... Land Risk-Takers Custodian € 06/06/09

....while the Developer invests “Intellectual Capital” of concept and services... Land Investors Land-owner, Council, Contractors, Risk Takers Developer Custodian Value Value 06/06/09

When the development is occupied... Houses Investors Occupiers Custodian % % Rental 06/06/09 Managers

...the Development Investors have a choice of selling their Equity Shares.... 06/06/09

...or keeping them for their pension 06/06/09

Everyone has a stake in the outcome.... 06/06/09

....with an interest in high quality, energy efficient housing .... 06/06/09

....because this lowers the cost of occupation over time .... 06/06/09

....which makes the Rental value higher and makes Equity Shares more valuable 06/06/09

So we go from a transaction model... Developer Property Buyer £ £ Property Buyer £ 06/06/09 Land Owner

...to a service provider model where property is never sold again... 06/06/09

...but service providers bring together Occupiers with properties... 06/06/09

...and property Investors with property investment 06/06/09

A Land Partnership is not an Organisation ... 06/06/09

...it does not own anything, do anything, employ anyone, or contract with anyone... 06/06/09

...it is simply a framework within which the stakeholders self organise ... 06/06/09

...with a mutual interest in developing land sustainably. 06/06/09

So let’s replace conventional secured debt with a new form of Community Equity... 06/06/09

...simply by Unitising pools of Rentals 06/06/09

… and turn the Risk Pyramid the right way up! Management Equity Investor Units Community Equity 06/06/09

It’s not Rocket Science 06/06/09

Thank You 06/06/09