Thursday, September 23, 2010

financing egalitarian communes where members have disparate financial means

How to you arrange temporary ownership of a commune, such as a co-housing arrangement, where each member is unable to provide equal down payments, but an eventual equal ownership status is desired?

This is as far as I know, not only an open important finance problem, but one that has been untouched.  Applications include all cooperative ventures and mutual insurance equivalents.

Marriage is a full commune.  It is a commitment to equal share from personal entitlement (70% of marriages in North America result in divorce).  A cohabitation arrangement for the purchase of co-housing involving multiple parties does not imply the same trust levels among the parties.  The main issue is that those who put nothing down are motivated to walk away from the property if the market value declines, while obtaining "free" capital appreciation if the market value goes up.  Thus they have no risk and extreme possible reward.

We will look at 4 general approaches to establishing a fair agreement between parties.  Each can have some advantages, and the choice is affected by laws of a jurisdiction (eviction laws, ability to walk away from property and mortgage).
First, If all parties agree to an equal share and cosign one large mortgage, the question becomes what is the value of cosigning to and for the members?
Second, Those parties putting up 100% for their shares can cosign a mortgage, and then reissue loans to those putting a small fraction of down payments at a profitable interest rate margin to reflect the relative (lack of) risk of each member.
Third, all investors put down equal minimum payment and then finance their share independently, or more likely collectively.  The question then becomes how to do this as efficiently as possible within the financial system, and since the answer is to finance collectively, how to minimize financing costs and the substantial risk borne by the lender.
Fourth, those investors who put up more upfront money could obtain a 1/x (1/20, in example of x=20 partners, buying a p=$100k house) share by putting down less than p/x ($5k) for their share.  Those putting less down would end up paying more than $5k for their shares + interest on the loans.  The justification is the relative risk of each owner to a drop in market value.  The question becomes how to calculate a fair discount.

All of these scenarios assume the concept of net partial ownership.  Even if there is mutual cosigning, each party is responsible for his actual share of the debt, so if 2 people buy a house, where 1 puts up all cash for his share, and the other puts down nothing, then even if they are equal owners, proceeds from selling the house are typically split in half, and then those who were responsible for debt for their share use those proceeds to pay down that debt.  In such a 2 person cosigning situation, if the 2 people buy a property for $100k that they immediately resell for a $10k loss (typical total transaction costs if resold the same day for closing price), then the first investor gets $45k back, but must pay the bank an extra $5k to cover his cosigning obligation, and thus the cash partner lost the entire $10k, while the debt partner lost nothing.  Note that an imposed fairness, as a baseline, is that all partners should be equally responsible for losses.  If the project loses $10k, then the partner who had no down payment should owe the partner who put up cash (at least) $5k.

Another concept the reader should be familiar with is the call option.  A homeowner with no down payment and no liability if he walks away effectively owns a call option on that house.  If it goes up in value, he's worth more, and if it falls he doesn't lose anything.  Call options on stocks and futures that expire 1 year from now at a price equal to the current market price are worth 2%-8% of the market price depending on the individual stock and how volatile its pricing is, and how uncertain its future.  It drops to 1%-3% when the market price is 10% above the call option strike price.

The first scenario (cosigning risk transfer privilege) is the most common approach partially because it is suited to marriages, and simplest, and partially because it satisfies banks.  A starting point in valuing the benefit of cosigning a loan is to grant the cash buyers a loan by the debt buyers in the event of a loss.  In the 2 person example, the debt buyer would owe the cash buyer $10K as an unsecured loan after liquidating the property.  If the debt buyer had invested 5K instead of 0, then no loan to either party would take place upon liquidation because both parties lost $5K.  Setting an appropriate interest for the conditional loan is a market agreement between high downpayment investors and low downpayment investors.  This can be fair to the cash investors if such a loan is likely to be repaid, and so basically only offers protection in the event the project is unattractive to the borrower since failing to pay due to hardship makes the conditional backup loan of dubious value.  Although, this arrangement transfers all of the risk (if loan is repayable) to the low downpayment investors, the arrangement can be attractive to them if cosigners reduce the interest rate of the loan sufficiently.  The appeal of this solution is relative simplicity.  An alternative is partial indemnity instead of full indemnity to the cash buyers.

The 2nd approach (relending cooperative) is similar to rent-to-own schemes.  It probably involves some right to evict and take control of a delinquent voting-rights-holder, but a delinquency option can be an "own-to-rent" right of abandonment by the borrower.  This approach can be used with many partners, and in any situation where partners must buy a share of a project (even without large secured loan).  With a large group, and bank involvement, the bank has a lending relationship with the partnership with individual investors co-signing.  The  partnership is owned in proportion to paid up capital, with senior partners (majority veto of further investment projects) having fully paid up capital.  The borrowers take out "semi-unsecured" loans from other stakeholders in the partnership (bank, partnership entity, and partnership investors), with terms that when fully paid they are granted senior partnership status, and proceeds from the sale of the partnership close out the loan.  The loans are open, such that borrowers may fully pay off the loan in order to participate in proceeds from sale of partnership, or gain voting status to stop such sale.  While interest rate charged to borrowers are set individually, a preferred model is to offer a premium over bank funding that varies according to paid up capital (and adjusts downward over time as more paid up capital is accumulated through repayments).  For normal borrowers, premium over partnership funding rate would reach 1% or less when a borrower reaches 50% paid up capital.  This approach creates a lending market for borrowers to choose from.  The open loan criteria means that borrowers can renegotiate at any time, and lenders are able to transfer the loan as well.  Transaction costs are minimized by a single standardized legal agreement where only interest rate and repayment rate are varied.

The third approach (equal minimal risk) guarantees that the ownership situation is fair and equal to all investors at all times.  The cost is likely much higher financing costs for those that would be capable to pay cash for their share.  Project organizers and investors agree to a minimum down payment and payment schedule from investors.  Those potential investors who are unable to meet the payment terms, can pool together and split 1 share.  In its simplest version, 1 lender (bank-like) lends the necessary proceeds above accumulated down payments to the partnership at a unified interest rate and terms.  In order to minimize the interest rate, the bank is offered terms of full forfeiture of individual shares and partnership assets after 6 months delinquency.  After 3 month's delinquency of one member/partner, the other members are offered the opportunity to take over the delinquent member's share obligations, and all of those that agree get an equal fractional share of that share.  No compensation is owed to the delinquent shareholder.  After 4 month's delinquency, the partnership can offer the membership share to outsiders with any proceeds for purchase of the share obligations going to the partnership.  Prior to "bank" repossession of the share, the partnership may vote to socialize ownership of the share by a majority to eliminate the share and distribute its obligations among all other shareholders.  The advantage of this structure is that all investors can walk away and abandon their share of the project, or resell their rights/obligations.  Investors with substantial capital can syndicate with the primary "bank" lender to form a lending partnership that acts as one, and where individual investors break even on the high interest rate charged to the partnership.  This is suited to high risk projects.  An interest rate premium that decreases over time, as the project matures and more paid up capital is accumulated, can make sense.  An example of 12% for first year with a 1% reduction each year for the first 5 years might be typical (improvements below), depending on loan syndication participation and overall project quality.  The ability to over-ride eviction laws in a jurisdiction can be important in permitting this type of risk taking by the lending syndicate.

The fourth solution (share discounts) is appropriate when partners with low capital are confident of the project's success.  This option involves cosigning loans by all partners.  Allowing full paying shareholder to underpay for their share, is direct compensation for their cosigning benefit and project participation.  It differs from the cosigning-risk-transfer-privilege (first solution) in that it involves a less speculative risk transfer to the capital-rich partners (if the borrowing partner must abandon due to health reasons or inability to pay, then an unsecured loan from them is worth little).  As a base-line for pricing, transaction costs of reselling the project at the same nominal price on same day of closing should be fully reflected.  So if those transaction costs are estimated at 10% of the project value, then all those who pay less than 10% down for their share "price" be increased by up to 10% while those who fully pay for their share should have their share cost reduced by 10%.  Note that we should not adjust for market risk (project value increasing or decreasing) because that is theoretically fully reflected in the purchase price.  While market price of assets reflect the cost of insurance and maintenance, the inequality of loss between those that fully pay their share versus those who fully borrow for their share, means that either the highest cash investors have full unilateral/veto control over insurance coverage and maintenance programs, or they must be compensated for democratic control of these issues by all sharemembers.   The first option is easier.  Spelling out insurance carriers and coverage together with maintenance policies (less important than insurance for most assets) is an alternative to succumbing to total insurance decision tyranny.  The one other factor that should be adjusted among sharemembers is the value of the call option held by low to no cash down members.  Its value(s) should be split evenly betweens sharemembers.  Estimating the 1 year call option premium for each sharemember can be done using the Black-Sholes formula where the strike price of each option is the project cost less the member's down payment.  Those members who hold a higher than average call option premium (low cash investors) as part of their share would pay the difference from the average to those who hold a lower than average call option premium (high cash investors).

The dynamics of the third solution are the most interesting.  If the project is abandoned by nearly all, then any person willing to take over project obligations can satisfy the lending syndicate, and the syndicate members have sunk costs motivating them to do so.  Project members with good credit ratings and borrowing power, can join the lending syndicate by borrowing at lower costs than they are lending, and securing the loan partially with their syndicate share.  This effectively makes the 3rd option an improved 2nd option, because it simplifies the loan into a single agreement.  In a large member project, the risks tend to be limited to market risks, because the network effects of a large group means relative certainty that one member's hardship causing loss of his share is assumed by another member or member's contacts if the project remains viably marketable.  While the project commits to a fixed payment schedule with no prepayment option, it can purchase a syndicate position from any syndicate member through market agreement (if it purchased the entire syndicate, it would have the same effect as repaying the loan in full since it would be paying itself).

In my next article, I will show how natural finance secured queued soft loans can help both fairly set interest rates in a manner continuously adjusting to market conditions, and meet flexible operational needs of a project.  Natural finance can basically help a large group of poor communalist nitwits fund an expensive project.

Monday, September 13, 2010

GDP and social policy - Improper politicization of statistics

The most common mistake in social sciences is measuring what is easy to measure, and then inferring that the result is relevant to performance.

When we smash an anthill, we guarantee full employment and frantic activity for the ants.  Similarly, destructive hurricanes in Florida significantly increases GDP and employment in Florida.  The activity of replacing destroyed homes and infrastructure is indistinguishable to economic GDP than the activity building new homes and infrastructure.  Yet the latter increases the nation's wealth, while the former merely restores it.

Distinguishing spending between durable, maintenance, and waste spending can hope to measure productive economic spending even if it focuses on the conceivably measurable economic value rather than all imaginable human wealth increases.  Measuring transactions measures to a large extent wealth transfer rather than value creation.  Making a new car creates value if someone needs the new car.  Buying a new car confirms that value creation and transfers wealth, and also increases capital for the car maker to make more cars.  Its an exchange of value rather than a transfer of value. Transacting on a used car is also an exchange  of value, but neither creates nor confirms value creation in the process.  The depreciation in price (from new) is not a waste but rather a natural maintenance expense given current technology levels.  The eventual need to replace doesn't negate a car's useful service life' value. Education also involves value creation whether paid or not.  Any payment for the conversation or diploma grant can be viewed as a separate side-transfer of wealth.  Legal and financial engineering where it permits the creation and consumption of value through contracts, charters and financing creates value by facilitating the creation of value.  Food, shelter, and healthcare are at their core human maintenance expenses.  The first two can all be viewed as value creating in that people would voluntarily purchase higher value options even if gruel and hovels were free, whereas healthcare can have a substantial extortion component in corrupted markets.

Gifts (negating satisfaction of benefactor) merely transfers value.  Theft destroys value.  The benefactor suffers stress and violation, and both the benefactor and beneficiary waste resources and anxiety over security (thief must avoid getting caught).  Security in general must be viewed as a waste.  Hiring a militia to guard your car does nothing to preserve or enhance the car's value, merely its possession.  The security forces further lose the opportunity to engage in value creation activities.  Both risk and corrupt market insurance are waste as well.  Transfering risk to a third party is a mere transfer of risk.  A social guarantee that a car accident has minimal financial impact on its actors has value, but the profit and bureaucracy involved in providing that guarantee is waste.  Barriers to financial, technology and social arrangements that would reduce that waste are waste.  Lies are similar to theft in destroying value.  They require a (legal) security force/effort to guard against.  When investors choose risky stock investment with inherent uncertainty, and vulnerability to management lies and betrayal, and perpetual refusal to issue sufficient dividends, they tend to gamble under delusion of greed.  The appetite for risk is a misguided lack of recognition for the distaste of capital losses.

Enhancing trust creates value (roughly out of thin air).  It lowers militia and legal security requirements, as well as diminishing concerns regarding lies and betrayal.  The Natural Finance Comptroller function is one technology that enhances trust.  Having a 3rd party control all enterprise agreements removes the uncertainty of avoiding obligations, and so makes suppliers, partners and investors more likely to trust deferred compensations, and more agreeable to partnerships with less upfront cash distributions.  Reduction in legal costs, and extra opportunities made possible by enhanced trust from 3rd party control are likely to favourably outweigh the costs of 3rd party control.

Back to GDP calculations, when you eliminate waste you decrease the GDP calculated economic indicator.  Distributing wealth widely accross society is a legitimate goal, and waste spending is one means to do so.  A more useful means are to use government taxation to fund grants and loans to projects that will create value.  In order to help re-employ those displaced by waste reduction.  A similar misinterpretation of economic indicators occurs when imports are viewed negatively.  If importing tube socks for $2, where the alternative is to produce them yourself for $5, then importing them gives you tube socks and $3 extra.  Economic value is the goods and services that satisfy needs and wants, not the little green pieces of paper that make people provide these.

EDIT: the purpose of this post is to outline political corruption of the GDP statistic.  That recessions are simply defined as 2 quarters of GDP decline, makes simple GDP manipulations through increased deficits a political tool to avoid the label recession.  Waste spending can be labeled economic strength or growth.  That national income transactions remain relatively stable can overlook the wealth destruction that has occurred in the same period (A durable wealth statistic is provided in comments), and so policy can misunderstand the health of the economy in its actions, or ignore simple innexpensive processes that can substantially increase wealth and value.

Monday, September 6, 2010

How capitalism harms innovation/capitalism

The relationship between financiers and entrepreneurs harms capital allocation, innovation, and entrepreneurial success is the longer title.  I dislike using the word capitalism because it is ephemeral, and without common meeting, and has practical corruptions that differ from its theoretical purities.  Capitalism harms or is anti capitalism becomes a sensible sentence.

Common shares determine ownership in a corporation.  Both in terms of voting power, and share of distributions (dividends or proceeds from sale of corporation). They have the same failing as general democratic institutions in that a majority shareholder or majority forming cartel obtains decision authority over the corporation.  The basis that all shareholders must be paid equally if they are paid is insufficient to ensure that majority decisions benefit all shareholders.  Entrepreneurs, managers and Financiers have different general objectives.  The financier wants to be paid back.  Entrepreneurs would tend to have grander vision and aspirations of empire than managers, but both seek employment benefits.

Corporate governance is on its face, a board of directors appointed by shareholders to monitor management's duty to maximize shareholder value.  In practice, for public corporations, management is very influential, often naming all board members with the president as chairman.   This occurs because most investors find it easier to sell their shares than to seek control of the board or fire management.  There is no widespread motivation to expose stock ownership as a scam since financiers need other gullible financiers in order to divest.  Hope and greed that delusions of stock value persist, prolongs the cycle of further financier participation in the scam.  We invent the matrix, and reinforce it.

The major conflicts that occur between management sympathetic directors and non controlling shareholders are reinvesting surpluses (into for example buying other companies) instead of paying dividends, and diluting investors by issuing more shares (many to employees).  Proof that buy and hold shareholder strategy fails is that  The average large corporation lasts 40 years before bankruptcy, and dividend payouts rarely compare to bond payments (which include repayment of principal at end of term).  The only genuine hope for corporate investor returns is through a takeover.  Both bankruptcies and takeovers are quite cyclical, but bankruptcies outnumber takeovers in both value and instances.  If buy and hold is foolish for 100 years, then it is necessarily foolish for 5 or 20 years.  Insiders, professionals, and stock promoters can sometimes make money by selling prior to collapse, but it is at the expense of foolish passive investors, and either through corruption or luck.  Proof that management of public companies control shareholders rather than perform their facial duty is they do not pay very high dividends with the confidence that shareholders will reinvest into the company.

For private corporations, companies who have yet to grow enough to become public or entrepreneurial startups, shareholder financiers need majority control, because they don't have the option of secession present in public ownership (they cannot easily sell shares) if they are dissatisfied.  Because of the ease of selling/secession and no duty to monitor management, most financiers prefer investing in public corporations despite it being a scam.  Entrepreneurs have difficulty finding financing for projects, because there are few willing financiers who fear the pitfalls of public company investing, and they need to insist on a high majority (controlling) share, which is unappealing to entrepreneurs.

Entrepreneurial funding is time consuming.  There is imperfect competition in that the first investor that shows interest is likely to be able to dictate terms.  Just as poor people are more likely to fail due to the high interest of sub-prime loans, ventures with too little return for effort are more likely to be abandoned by entrepreneurs.

Traditional debt financing has problems as well for both investors and entrepreneurs.  For investors and entrepreneurs, other and future debt, or shareholder dividends, makes the security of the debt completely unknown, and so pricing of the debt either must approach worse case scenarios, or be unfair to the lenders in the event of present or future management substantially increasing leverage.  Debt financing further tends to be limited to company asset value.

Real innovation depends on startups and private companies.  Public companies that survive often do so by blocking innovation through barriers to entry, or often through the only known free market: the market for politicians.  The artificial attractiveness of public corporate funding hurts the financing available for startups and private corporations, and thus hurts innovation and entrepreneurship:  capitalism harming innovation/capitalism.

This post has mostly been addressing the principal-agent problem.  Agents (management) have their own agenda despite a pretense of duty to Principals (shareholders).   It's a pervasive social problem, and present in all agency relationships.

Natural finance solves the principal agent problem by making management/labour the only encouraged shareholders, and therefore a principal only relationship.  Financiers are paid first, and as quickly as possible.   Individual financier investments have a known value proposition (far easier to evaluate than common share proposition) at the time of investment, and can never be diluted.  By providing entrepreneurial control and freedom, the necessary motivational drive for successful innovation is present.

Introduction to natural finance