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

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

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

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

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

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

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

8. ...and Peak Oil 06/06/09

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

45. The Result? Equity Credit 06/06/09

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

75. 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

122. ....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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

141. It’s not Rocket Science 06/06/09

142. Thank You 06/06/09