Sunday, February 28, 2010

Unitising Residential Property

Articles on this blog are intended to introduce the reader to the nature and shortcomings of our financial system and ways to change it to free us from debt slavery

Written by Chris Cook - September 03, 2009 9:38 AM
Page 1 of 2

Only in Scottish law is there to be found a pragmatic, “not proven” middle way between the absolutes of guilty and not guilty. Perhaps such open-minded pragmatism is the reason why the Holyrood parliament's Economy, Energy and Tourism Committee listened intently earlier this year to the unconventional financing options which the Nordic Enterprise Trust (NET) has developed in Scotland with support from Norwegian state agency Innovation Norway.

It was clear from informal discussions with members of the Edinburgh parliament that the effect of the credit crunch on Scottish housing is a far greater political hot potato than renewable energy, the subject on which we were giving evidence. The housing crisis is currently manifesting itself in several ways, including a rise in repossessions and homelessness; a shortage of development credit, particularly in the private sector but extending to the public sector; and the effect of the cessation of development on affordable housing.

We believe that there is a simple but radical partnership-based new solution – co-ownership – which we are prototyping in Scotland but could be applied throughout the UK and even internationally.

Public And Private

We all take many things for granted, and one of these things is that when say public sector we mean “owned by government” and when we say private sector we mean “owned by a limited company”. But, as the city of Glasgow has realised, there is an emerging alternative to the limited company. Enter the UK limited liability partnership (LLP), which was quietly introduced in April 2001. The LLP is the simplest and most flexible legal entity ever created; the agreement between members is totally open, to the extent that it need not even be in writing. It combines the best qualities of a limited company with the co-operative values of a partnership.

Glasgow has at least four municipal LLP organisations, which engage with private sector partners to provide services such as car parking, market premises, and buildings for the use of the local community. But these municipal LLPs leave financiers and ratepayers alike on the outside, which means that they are just as constrained by the credit crunch as any other organisation. The “land partnerships” which NET proposes are not organisations but frameworks for investment in municipal assets of all kinds, in particular for investment in sustainable and affordable housing.

Introducing Public Equity

A land partnership does not own anything, employ anyone, contract with anyone or even do anything. It is a simply a framework agreement between the various stakeholders. Land ownership remains with, or is transferred to, a public custodian, probably a local municipality.

We are not asking land owners to give their land away but to invest the value of the land/location, i.e. the right to occupy it exclusively. Whether or not it is municipalities or councils who invest the land, planning permission also has a value and municipalities and councils would invest the value of that consent. Once materials, labour and services – or money to pay for these – have been deployed, then valuable new housing is the result.

Once building has been completed, occupiers pay an affordable rental for the use of the investment made in the land/location. This “capital rental” will then be indexed to a suitable measure of inflation. It is also possible to imagine a separate payment purely for the use of the location.


This is the alchemy. The pool of rentals which we have created is simply divided into proportional units and investors are invited to buy these units of public equity. So units are shares...but not shares as we know them.

Investors who have seen their returns vanishing as interest rates spiral towards zero would be ready buyers of an investment such as this. Units offer a reasonable, index-linked return based on property, but with low risk since affordable rentals are by definition more likely to be paid. Units are a perfect investment for risk-averse investors such as pension funds (although not UK pension investors – for tax reasons), sovereign wealth funds, and even Islamic investors (given that no debt or interest is involved).

To all intents and purposes the proposed “rental pools” are identical to real estate investment trusts (REITs), but with the key attribute that they are redeemable against property occupation. Unlike conventional units, which typically trade at a discount (occasionally at a premium) to the market price of the underlying asset, if the market value of the units were to drop below the market value of the rental stream then property occupiers would buy and redeem them.

For occupiers there is an end to any stigma of tenancy as they literally become co-owners and have a responsibility to maintain the property in good order. If they are able to pay more than the affordable rental, they automatically buy units. Even if occupiers have no spare cash, those who either assist in the initial development of the property or subsequently maintain their property in good order will effectively receive “sweat equity” units. This is because they will be able to keep the maintenance/ depreciation allowance applied to the building (since land/location does not depreciate, although its value may change).

A borrower under a mortgage contract may be foreclosed – no matter how much equity he may have – if, for some reason such as unemployment or a credit crunch, refinancing is impossible.

In co-ownership, on the other hand, an occupier may only be evicted if he fails to pay the rental and has no more units of equity to use instead of cash.
Sustainable Development

The conventional transaction-based property development model is well described as “the four Bs: Buy, Borrow, Build, and B****r Off”.

Under the existing model, developers have no interest in energy efficiency or good quality since these cost money and reduce transaction profit. In a land partnership development, the individuals or enterprises (such as housing associations) who manage development have an interest in high standards of quality and energy efficiency because this lowers the cost of occupation over time and makes the units they will receive more valuable.

The approach for contractors is firstly to invite them to invest their costs, which may be possible for businesses such as architects and engineers but not so straightforward where there are costs of materials and labour to consider. However, whether or not contractors are willing or able to invest their costs, they will be expected to receive an agreed profit margin in the form of units, and this will align their interests with those of other investors. In this way, we minimise the amount of development risk capital needed from public or private investors.

Once the developed property is complete and occupied, the manager member – again, possibly a housing association – also has an interest in doing a good job because that will increase the value of their proportional partnership equity share in the rental.

Unlocking Public Equity

Development of new housing takes time and development credit is in short supply. So we propose that some of the investment tied up in existing housing stock should be recycled and used to develop new housing. We propose to simply replace existing government, municipal and housing association borrowing with units of a new class of Scottish equity, which dramatically cuts financing costs.

Defusing The Debt Bomb

New medicines are often tested on the most desperately ill patients and we believe that our proposal could first be tested as a solution for those increasing number of Scots who are currently suffering the trauma of losing their homes to debt. So distressed properties would be transferred to a custodian, an affordable and index-linked rental would be set, and units in the resulting “pool” of affordable rentals would be sold to long-term investors, with the scheme managed by local housing associations.

For the banks, the exchange of distressed debt for units would give rise to an asset with far more resale value than any conventional security or restructured loan, which retains a debt obligation. Moreover, the fact that the rentals composing the income are affordable will mean they are more likely to be paid, and this relative certainty should justify a higher price and lower rate of return.

In this way, distressed Scottish borrowers may shake off the shackles of mortgage debt and the Scottish government's limited funding to alleviate their plight may be deployed as a revolving transitional investment in the pool while new investment is introduced by skilled Scottish financial services providers.

A New Wave Of Housing Investment

Using the co-ownership approach, international and domestic investors may refinance existing UK public and housing association debt. The massive resulting pool of development credit could then be deployed in networked sustainable development of affordable housing throughout the UK in such a way that the interests of all stakeholders are aligned.

It's not rocket science and (tongue-in-cheek) the NET even has a name for Scottish use of what is essentially a new form of partnership-based national equity: the Scottish Futures Trust.

This is an expanded version of an article published in the summer 2009 edition of Scotregen, the journal of SURF, Scotland’s independent regeneration network. Chris Cook is Principal of the Nordic Enterprise Trust. He is a well-known commentator and expert on the petroleum markets and peer-to-peer finance. He was formerly Director of Compliance and Market Supervision at the International Petroleum Exchange.

Friday, February 26, 2010

Peer-to-Peer Finance: A Flight to Simplicity

Articles on this blog are intended to introduce the reader to the nature and shortcomings of our financial system and ways to change it to free us from debt slavery

Link to article source here

By Chris Cook
February 25, 2009

Internet activist John Gilmore famously said, "The Internet interprets censorship as damage and routes around it." A key event of the Internet age was the invention of Napster, the direct online music-sharing program that helped erode the business model of the global music industry. This capability of the Internet to route around middlemen is becoming more apparent. A reader of the Financial Times in December won £10,000 for identifying peer-to-peer lending through the Internet as the "next big investment idea."

How such a directly connected financial system could work is a question that has interested me for almost a decade.

At a recent conference in Tehran on the current financial crisis, one of my fellow speakers observed that "it is not possible to solve 21st century problems with 20th century solutions." I agree. The emergent partnership-based enterprise model, however, has evolved in response to the challenges of this direct Internet connectivity.

Finance consists of three things: credit, which facilitates trade and enables the creation of productive assets; investment, which consists of financial claims over productive assets such as secured debt (e.g., mortgage loans); and equity, which is an ownership interest in a corporation, and typically exists in the form of shares.

Credit and investment may be achieved without the intermediation of banks. Since bank capital will be further depleted as the credit crunch spreads into the productive economy, peer-to-peer finance offers a solution from an entirely unexpected direction.

Direct Credit

Trade sellers have extended credit to trade buyers for thousands of years. As trade has developed nationally, regionally, and globally, one of the key enabling factors has been credit intermediation by banks. This intermediation protects sellers by taking on the credit risk of buyers and enables trade to flow by providing liquidity to sellers.

It is possible to dispense with a credit intermediary and provide such a framework of trust through the use of an agreement—a guarantee society—whereby sellers and buyers collectively provide a mutual guarantee. This mutual guarantee may then be supported by provisions made by both seller and buyer into a default fund in the hands of a neutral custodian.

A service provider could then set guarantee limits, operate the accounting system, and deal with defaults in return for a fee. The crucial advantage for banks of such a guarantee-society credit-enterprise model is that they would no longer have to put capital at risk by creating credit based upon it.

Direct Investment

When we distinguish the public sector from the private sector, we are actually distinguishing between enterprises and assets that are owned by the state and those which are owned by that specific enterprise model known as the joint stock limited liability corporation.

In recent years, media attention has focused on developments and events in the field of credit. The emergence of new generations of alternative investment vehicles—such as income trusts, real estate investment trusts, exchange traded funds, and hedge funds constituted as limited partnerships—has passed relatively unnoticed.

In particular, there has been an explosion in the United States of the use of the simple and flexible new partnership-based Limited Liability Company. In Britain and elsewhere, an even simpler form—the Limited Liability Partnership—is emerging at a phenomenal rate for purposes never intended by legislation introduced with the intention of limiting the liability of partners in professional partnerships.

Such partnership-based entities may be used as framework agreements—not organizations—which bring together investors with users of investment in a capital partnership. In this way, it is possible to create new revenue- and production-sharing mechanisms for direct investment in productive assets of all types, and particularly in real property and in energy assets through what I call "unitization."


Let's consider how this might be used to refinance a portfolio of distressed mortgages. The properties are transferred to a neutral custodian, and an affordable rental is agreed upon. That rental is then index-linked. The resulting Rental Pool is divided into proportional units which are allocated between investors and a suitable management consortium.

For the "co-owner" occupier, this is a new form of rent-to-buy, since any amount paid in excess of rental will buy units. For the "co-owner" investor, units provide a reasonable, index-linked, secure revenue stream, ideal for risk-averse long-term investors such as pension funds. For banks, this is an optimal form of refinancing through a "Debt/Equity Swap."

Similarly, we may finance a wind turbine simply by creating units redeemable in, say, 10 kilowatt hours of energy and selling these to investors. In the United Kingdom, the sale of between 30 and 40 percent of production finances the turbine, and with a few percent of production to a manager, the balance is pure surplus.

Direct peer-to-peer investment gives rise to shares, but not as we know them. Once again, we see a role for banks as service providers, appraising investments, advising investors, and providing liquidity—all classic investment banking roles. As with direct peer-to-peer credit there is again no need for banks to risk capital by creating credit based upon it.

The enabling factor for a new generation of peer-to-peer finance is a new generation of networked partnership-based framework agreements and entities. The work of visionaries like David Johnson of New York Law School and Oliver Goodenough at the Vermont Law School in creating the new Vermont Virtual LLC is a major advance in this direction.


A generic clearing-union network of direct financing will enable a simple but radical new approach to global economies. It could enable systemic fiscal reform based upon taxation of privilege rather than earned income, and it also offers new solutions for financing public assets. Most exciting of all, it enables a new networked generation of global markets, and even the potential for a "New Settlement"—a Bretton Woods II—establishing a new global architecture for world trade.

Chris Cook was formerly director of the International Petroleum Exchange, and is now a strategic market consultant, commentator, and enterprise architect. He is currently developing new partnership-based enterprise models and financial products based upon their application to Internet market networks.

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