Peak Credit

Peak Oil - the theory that we may be at or near a peak level of oil production - while remaining controversial is at least now respectable. But is the continuing credit crash masking another inconvenient truth? Might banks now be experiencing the aftermath of peak credit?

What is a bank anyway? They are actually credit institutions. They create the credit - as interest-bearing loans - which constitutes the life blood of the economy. This credit actually is the bulk (or more than 97%) of the money in use in the US, the rest being notes and coin.

Banks stand between borrowers and depositors: they extend credit to borrowers and receive credit from depositors. So they are also middlemen or credit intermediaries.

But let's stand back for a moment and consider the actual economic function of a bank ... in fact what it actually does is provide a guarantee to its depositors that its borrowers' credit is good. The interest charge the bank makes for doing this has to cover the interest it pays to depositors, operating costs and default costs, and will normally produce a net profit.

If you think about it, trade credit from seller to buyer costs nothing to create, and of course bank credit costs nothing to create either: so it is the implicit bank guarantees that represent the economic value they provide. Regulators - overseen by the Basel-based Bank of International Settlements - specify and monitor the amounts of regulatory capital which must be held to support this guarantee.

The problem has been that in recent years banks have been outsourcing their guarantee to investors: permanently through securitization, temporarily through credit derivatives, and partially through insurance, by monoline (ie with a single line of business) credit insurers, such as Ambac.

By using investors' capital to augment their own, a much greater pool of credit has been created than banks could ever have sustained on the basis of their own resources. Unfortunately, this has been done in such an opaque way that no one actually knows who is at risk. The market in such investments has now frozen as investors have gone on strike, probably permanently.

Asset-based and deficit-based finance

Credit is essentially an IOU and is very different from equity (for example, shares in a corporation). We can think of credit as deficit-based finance, and equity as asset-based .

Problems arise when deficit-based credit is created and used to buy pre-existing assets rather than to create new assets. This almost invariably leads to asset price bubbles, the first of which was John Law's Mississippi Bubble in France in 1718. A bubble begins when asset prices lose touch with any revenues generated by the assets and continues to inflate until no further borrowing is available. Asset prices then collapse in a wave of defaults, which ruin borrowers and sometimes the banks.

In the US, this guarantee outsourcing led to a pyramid of cheap credit and caused - among other things - the mother of all bubbles in US property prices.

Looking back on it now, it seems clear that the peak of the US property bubble may actually have been peak credit.

What now?

New capital is needed to support the creation of new credit, but the process of rebuilding bank balance sheets cannot even begin until it is clear that the property bubble has deflated. The investors in outsourced guarantees are long gone, and we are already seeing the specter of a credit famine stalking the land.

Perhaps the Internet will ride to the rescue? The pervasive spread of the Internet is increasingly connecting individuals directly peer to peer. The revolutionary Napster music-sharing service mapped the route to the creation of peer to peer lending sites such as and Perhaps banks as credit intermediaries are no longer necessary, and will morph into a future as service providers?

One possibility is for a central bank to create and issue credit directly to borrowers, who could then pay interest into default funds. These pools would support a guarantee backed by governments.

In fact, why should not the Treasuries issue credits directly? Hong Kong has been hugely successful without a central bank, but with a Monetary Authority supervising conventional bank credit creation.

In a dis-intermediated model, banks need no longer put any capital at risk by creating credit based upon it, but would instead manage the creation of credit. So they would operate as a service provider setting guarantee limits, handle defaults and administer systems, all under the stern but benevolent gaze of a monetary authority.

These risk-sharing pools would enable the creation of the unsecured credit that finances development and economic growth. Now, this is all very well for financing the creation of productive assets, but if used to acquire existing assets may still cause asset bubbles. This is where a new form of asset-based financing comes in - unitization.

All eyes have been on the world of credit, and the spectacular returns possible through the gearing which causes bubbles. In the meantime, however, there is a quiet revolution going on under the radar in asset-based finance.

Perhaps the best-known examples have been income trusts and royalty trusts, still commonplace in Canada and very popular in Australia until the tax treatment changed. These unitize rights to part of the gross revenues of listed corporations.

Long-term investors, such as pension funds, love these and it's not difficult to see why. They are getting their hands on corporate revenues before the management does: would you rather drink the water before it goes into the bath, or after it comes out of the plug-hole?

Similarly, the recent Blackstone initial public offering in the US was not a sale of conventional shares but of partnership interests in Blackstone revenues. Other rapidly growing asset classes are exchange traded funds (ETFs); real estate investment funds (REITs) and Islamic Sukuks - all asset-based.

Reversing the polarity

There is an urgent need for the refinancing of literally trillions of dollars worth of property-backed securities and debt. My proposal is to achieve this through the creation of a new generation of asset-based property finance.

A capital partnership is essentially a new type of partnership-based evergreen leasing framework. Property freeholds are held within the framework by a custodian with property occupiers and financiers as co-owners, as follows: Occupiers pay a capital rental for the use of the property. An affordable, but index-linked, rental is then set. Units in pools of property rentals are then sold to long-term investors. Any rental paid by the occupier before due date automatically becomes investment. When an occupier's income as an investor equals the rental due for the use of the property he is - in economic terms - the owner.

The result is property finance which is affordable since: occupiers pay to maintain the property but are not repaying a loan; an index-linked return may be set at a lower rate than a conventional return. For investors, the affordability of the finance means their return is much more certain.

There is an ocean of money seeking secure real returns. What better way than to invest directly in units of affordable property rentals? Through a debt/equity swap the enormous overhang of property backed credit slowly strangling global financial system could be refinanced.

Banks would again be operating in a service provider role, assessing investments, bringing investors together with investments, and providing necessary liquidity, ie investment banking.

I believe we have indeed seen peak credit. The unitization of property rentals could not only avert the looming crisis in the US but conceivably even give rise to national equities alongside shrunken national debts. Hong Kong is perhaps better placed than anywhere else to achieve this, being half way there already in both financial architecture and tenure.

(Copyright 2008 Chris Cook.)

Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and commentator.

This article was published on 3rd April 2008 in Speaking Freely, an Asia Times online magazine: "Peak Credit and the Fight to Simplicity"

See also:

Chris Cook - 5/72008 - Power Point Presentation at Bar Camp Bank: "Peak Credit"

Chris Cook - 2008: "Peak Credit -The Aftermath" - the UK Approach

Chris Cook - 2008: "Peak Credit - Bear-Faced Robbery - the US Approach