Friday, December 31, 2010

Options as a basic life skill

There are frequent calls to include personal finance topics as an essential life skill that should be taught in high school.  I'd suggest that options topics are important life understandings as well.  These include:

The legal concepts and of obligations and rights.  Essential to understanding any contract.  Options are the simplest form of rights and obligations triggered by a (hopefully) simple measurable event.
The equivalency of short puts and calls to buy and sell offers, and the advantage of doing so if the offer has relative permanence.
The equivalency of owning an asset with a long call and short put position.

The ability to understand this last point of option equivalencies to assets and financial instruments, is key to understanding alternative financial instruments including natural finance.

A corporation is fundamentally a call option (with unlimited duration, strike price of 0) given by bond holders and other debt holders to shareholders.  Shareholders are entitled only to surpluses above and beyond the full repayment of bond holders.  Through bankruptcy legislation and process, bondholders effectively hold a put option (unlimited duration strike price of somewhat indetermined less than zero) given by shareholders for taking over the company in event of insolvency.

Options can create value out of thin air.  Someone who owns a stock currently valued at $50 can decide to sell it if it reaches $60, and not sell it if it drops to $10.  By writing an option with strike price of $60, the stock owner has the exact same risk profile as his current attitude, but is paid to keep it.  The buyer of the option gains all the benefits of the stock rising above 60, with no risks of it dropping far below $60.  If the option writer is indeed paid to do something he would have done anyway, the value creation is entirely captured by him, though the buyer voluntarily pays what is a fair price to him.

Insurance also has strong options analogies.  A policy holder who has replacement value coverage for an asset holds a put option on that asset at strike price of the replacement value less deductible.  It isn't quite a pure option in that the rights to exercise are convoluted, and can be objected to by the insurer.  In fact, when replacement value is well above market value of the asset, trying to exercise the policy holder's put is likely to arouse suspicions of insurance fraud.  Alternative insurance structures could create value by reducing the put's strike price.  It would lower premiums, and increase trust by both insurer and insuree by lowering suspicion of fraud if there is a claim.

Progressive taxation can also be seen as a series of call options you have been made to grant to the government/society.  Progressive taxation is widely accepted as inherently fair.  The argument for it is that those who extract the most value from society should repay society more than those less fortunate or able.  Resulting income equality staves off social unrest.  The interesting aspect of these options obligations is the relative complacency those involved have towards ever increasing taxation obligations on marginal income.  2 factors explain this complacency.  First, psychology makes you more docile about payment when it is based on success and you can afford it.  Second, we universally prefer trading off fixed risk for less potential ultimate reward.  A flat $10K per US adult in taxes would not pass democratic approval regardless of republican PR capabilities.  Offering an increased share in our success is an attractive trade to lower the chance of destitute bankruptcy.

This later concept, of universal preference for trading off risk and certainty for return,  forms one of the basis for using capped queued soft loans in natural finance.  When buying a security, issuing the seller a call option at double the purchase price is unlikely to meaningfully affect the transaction's price or attractiveness.  The cap also serves to self-mitigate greed and desperation at time of financing, and enhance the predictability of investor returns.

The importance of options as a financial engineering instrument is its design to compartmentalize and subdivide risk.  The insurance analogy transfers risk from those that can't afford it (policy holders) to those who can diversify the risk among several policies.  All value creation through financial engineering is through either risk reduction or trust enhancement.  Natural Finance focuses on both these forces to design enterprise structure and financing.  Understanding natural finance, depends on understanding options.  Understanding options also enables understanding financial engineering and solutions in general.  A population that is educated in these matters is better able to participate in financial solutions, and hopefully understand and defend against predatory financial propositions.  Whether finance concepts best belong at a high school level, or treated as a liberal arts undergraduate compulsory, strengthen a nation's intellectual and economic capacity.

Sunday, December 12, 2010

Environmental consciencious choice is the cheapest choice

Crude oil burning is considered a main contributor to global warming and destined to melt icecaps that will flood and kill 100s of millions of people.  It also damages air quality, and is a scarce resource which needs to be diversified from.  While humans have a collective incentive to minimize such huge costs through simple and obvious national taxes on oil and gasoline to curb and shift demand to other sources of energy, sects of people can profit substantially from drill baby drill, and burn it baby burn it.

Environmentalism can confuse and oversimplify "all oil based products are bad".  First, oil is extracted for its gasoline, kerosene, diesel and heating fuel contents.  Oil refining separates these components out of crude oil.  Plastics are produced from a lesser byproduct of fuel extraction.  Since plastic does not emit greenhouse gases (I'm not positive to what extent that is true), and is essentially produced from permaculture/recycling principles on oil, vilifying plastic on anything but its potential carcinogenic properties has the same tenuous misplaced objection as vilifying leather for the murder of suboptimal calorie and protein production vehicles.  Both are mere byproducts of industry that persists without the byproduct existence.

Polyester and spandex are oil based plastics.  Cotton is a natural renewable plant based fiber.  Cotton's price has spiked substantially recently.  Cotton production displaces food production, and price spikes cause it more-so.  I don't believe there is a morality argument when choosing between cotton and polyester.  Rather purely a choice on fiber value.  A natural fiber's only benefits is that health properties have had millennia to be investigated/understood and non-toxicity can be more safely presumed.

Hemp and bamboo are prodigious plants capable of supplying vast amounts of textile and wood materials.  Strength and weight properties make these materials suitable for even bicycle frames.  They are not so perfect as to replace all wood and textiles, though they certainly have superb ecological properties, and deserve promotion on those grounds.  Other woods grow more easily in certain locations, and as a result of past investments, are harvested and processed in large scale, and are closer to North American markets.  The most ecological choice short term is to use what is available near by, now, and most cheaply.  Shipping small batches of bamboo product from Asia is economically disadvantaged because it is economically and ecologically expensive to transport.  It is thus important to understand bamboo as having long term ecological sustainability while realizing that today's ecological choices remains today's local economic choice.

Wikileaks documents aren't necessary to prove corruption of the collective interests not to drown millions.  Simple innaction is.  The political forces in favour of Oak, Maple or Teak are weak and conflicted, and incapable, in my opinion, of suppressing the long term viability of bamboo.  Taxing carbon gas emitting fuels is a perfect way to guide ecological choices through economic choice.  Taxation-invisible-hands are necessary when the social ecological costs on outsiders to transactions cannot be captured any other way.  Such taxes are helpful even if the proceeds aren't earmarked for atmospheric cleansing or polar cooling.

While economic choice is usually the same as ecological choice, it is important to correct that choice when it is distorted.

Sunday, December 5, 2010

Natural Finance for Income Property ventures

Rental/hotel income property owners typically try to maximize leverage.  They use established real-estate lending facilities led by banks, and larger collectors of properties are able to structure as a REIT (real estate investment trust) which provides investors with a shareholder stake of property price increases as well as regular distributions of property income.  Natural Finance can supplement traditional mortgages, and replace REIT structures.

Investing in Mortgages can be more attractive than bonds because cashflow yield is higher (principal repaid along with interest monthly), and investing in REITs can be more attractive than stocks for its balanced cashflow and share of potential property appreciation.

For an income property investor, finding the first 70-80% of investment through a bank mortgage is hopefully easy.  Funding all of the rest with other people's money is difficult because the smaller investment stake of the owner, the greater the risk to investors that the property value might fall below the purchase price and be abandoned by the owners. When gathering remaining funds from several junior/minority investors (either in equity or loan form), these investors should have concerns over auditing standards and ponzi/madoff schemes.   Such investors both require high returns to invest and are scared off by the suspiciousness of high promised returns.

 Natural finance is both compatible with traditional mortgages as a supplement, and superior to them.  They offer the same general philosophy as stock investment in that payments to investors are based on the availability of surpluses and cashflow.  They are far superior alternative for stock investors, because a natural finance corporation is obligated to ask for more money for future projects instead of hoarding surpluses, and corrupting them for management discretion.  Distributing surpluses fully is a typical promise of real estate income investments, and so formalizing a real estate corporation under natural finance principles provides investors with the assurance of following through on those promises.

There are 3 entrepreneurial monetization ambitions:  operating income, management fees, and capital appreciation.  NF in addition to separating ownership and capital can also facilitate the separation of the 3 interests.  First, mortgages and natural finance queued soft loans are each primary claims on the operating income of the venture.  Mortgages are a hard claim in that they are owed regardless of whether the income is generated.  Queued soft loan bidding process allows each investor to bid according to his confidence in the sustainability of the operating income, but such investment remains a bet primarily on the eventuality and sustainability of that income.  In a recent post on open partnership mechanics I showed how and why entrepreneurs might transform their enterprises into an egalitarian partnership (commune) using set or democratic entry prices for members.  Since entrepreneurial drive generally involves sometimes irrational need for control, a founder's reluctance to allow open membership can be overcome by binding the partnership to a management services contract (for a set term) for his services prior to opening membership acceptances.  The management and operations services company can also be a natural financed commune if the entrepreneur chooses it to be, and thus all 3 monetization ambitions can be marketed independently to investors and partners, depending on which area which investors are most interested/confident/hopeful.

While providing financing more cheaply and within the flexibility of actual cashflows of an enterprise while simultaneously providing better returns for investors are important and sufficient benefits,  independent comptrolling of the enterprise is especially valuable for minority shareholders in private enterprises.  An independent comptroller is better security for investors than independent accounting audit.  Transactions are monitored and approved live, and funds and accounts secured, rather than the auditing process which provides an after-the-fact tracing of events and transactions by a firm that is essentially under a revocable employment-services contract and that is willing to provide all permissible favourable-to-management interpretation of transactions.

The benefits to enterprise of an independent comptroller is that first, it attracts investors and you can pay them less if you provide them with more security.  Second, its less expensive than the regulatory compliance and auditing costs of public companies.  Third, an independent comptroller allows the enterprise to use debt (QSLs) as currency with all of its stakeholders, allowing it to defer compensation and payments, without forcing its recipient-partners to rely on the entrepreneur's faithful loyalty to his contracts, or personally conducting the due diligence necessary to ascertain the value of promised securities.

For monthly income property ventures specifically, the comptrollership function is less time consuming (expensive) than most other businesses, since financing transactions are generally few and large, valuation of projects is very predictable, and little to no mediation and consulting on projects and agreements is necessary.  The comptrollership function in an income property venture is primarily limited to ensuring funds stay where they are supposed to, funds are paid when they are supposed to, and executing operations are being done dutifully (generally easier for income properties), including verifying the existence of buildings and renters.

Saturday, December 4, 2010

Queued Soft Loans vs traditional loans. - Math

Natural Finance uses queued soft loans as principle financing instrument.  Presented here are details of the financial advantages of queued soft loans.  Secured queued soft loans are similar to open interest only mortgages in that interest and depreciation are paid each month.  General (or unscured) QSLs have no fixed payment amounts or dates, but rather controlled payments based on cashflow.

Consider a multi-unit residential property investment that cost $1M to buy, and generates $100K/yr in profits.  If seeking to finance the entire amount, a shrewd banker might calculate that the applicant entrepreneur would say yes to 10% interest only mortgage,  on the basis that he may earn a maintenance/management salary, and would gain if the property value increased.  At a 10% mortgage interest, the venture would pay $1M over 10 years to the banker, and would still owe 1M at the end of 10 years.

As a General QSL at 10% interest, after 10 years, over 337K is repaid even if no new investors buy out existing 10% loans. This online spreadsheet clarifies the loan dynamics on a yearly basis

The main advantage of natural finance queued soft loans is that interest rates charged is brought down by new investors buying out existing ones.  In our example, after 1 or 2 years of operating with 100k in operating profits, many investors would consider lending to the project at 8% attractive.  Even our initial shrewd banker who had the power to insist on the initial 10% would be entirely content to reinvest at 8%, after both operational soundness is established as well as demonstrated competitive investor interest.  Under natural finance, if there is $1M in the world content to invest in your project at 8%, then the natural/average interest cost will fall to 8%. After 5 to 10 years, after substantial equity has been built up, the natural finance rate can drop to 6% or less.

A traditional interest only mortgage at 7.63% interest, where any surpluses after interest costs are used to pay down principal on the mortgage achieves the same 10 year paydown rate as a 10% QSL.  As shown on sheet 2.  This means that 10% natural finance loans are equivalent to 7.63% traditional mortgage both for the enterprise, and  for total investor repayments over 10 years. Note that if an investor is repaid within 5 years, he will have earned substantially more interest under the natural finance option than under the mortgage option.  The first $323K of investment is repaid in 5 years organically, but substantially more can be repaid if new investors come in.

A further advantage of natural finance loans is the tax advantages to the enterprise.  By repaying principal earlier (retiring the head-of-queue loans that are repaid), natural finance allows higher interest to accrue (tax deduction) even when it is not paid immediately.

Secured QSLs are almost equivalent to interest only open mortgages when there is no depreciation on the secured asset (such as real estate mortgages).  The differences are in fact advantages.  First, the obligation instead of the right to pay the mortgage down under specific surplus conditions means additional security to the lender (who always retains the option of reinvesting any repaid amounts).  Second, and most importantly, the fact that natural financed corporations are independently comptrolled means that expensive government loan registration services are not necessary, and that all enterprise contractual obligations and loan covenants, such as insurance requirements, are monitored and enforced.  Thus a theoretical risk free loan, is made practically risk free and cost free.

The cash flow of secured QSLs is identical to the interest only mortgage model shown on sheet 2.

The primary consideration in setting interest rates on real estate is the loan-to-value ratio.  It is generally considered completely safe to lend $500K on an insured property worth $1M to anyone, because it is generally certain that the proceeds from foreclosure would exceed the costs.  Because of this, when loan to value is 50% or less, the very lowest financing interest are available almost regardless of the credit quality of the applicant.  We will use 5% as this risk-free interest rate.

A hybrid of secured and unsecured QSL natural financing is shown on sheet 3.  A 50% loan to value secured QSL of 500k @5% is used, and the remaining 500k loan is through general unsecured QSLs. @10%.  Natural finance insists (exceptions are outside this context) that surpluses are used to pay all general QSLs ahead of secured QSLs.  This hybrid model generates 503K of equity over the first 10 years, and all of those investors who chose unsecured QSLs are repaid in full.

Unsecured QSL investors can never be diluted by future security issuances.  All future QSLs will have lower payment priority than their QSL.  Natural Finance encourages Capped QSLs which provide further certainty to investors.  For example, the first $200k principal in queue position is guaranteed to be repaid with full interest or with $400k (double the principal value) if lifetime cumulative operating surpluses of the venture either exceed the amount owing or $400k.  Secured QSLs have payment priority for monthly interest payments and to be paid off if secured collateral is sold.  Because unsecured QSLs use simple interest instead of compound interest, and as shown by the linked spreadsheet, that a 10% QSL rate is equivalent to the enterprise in the long term (10 years) to a 7.6% compound rate,  investors that are bought out or paid off early (first few years), make a much higher return on what turns out to be a short term loan.

Natural finance provides higher returns to investors and less risk, and provides lower financing costs to enterprise.  It is therefore naturally superior to traditional finance options.