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(It is the Structure: Not the Index Chosen)Global Access to Capital and Deliver a Stable/Known Purchasing Power

April 8, 2018

Global Access to Capital and Deliver a Stable/Known Purchasing Power

 

(It is the Structure: Not the Index Chosen)

 

Regarding the recently released work, Sovereign GDP-Linked Bonds:  Rationale and Design by Robert Shiller , Jonathan D. Ostry and James Benford,  we considered the challenges such designs must necessarily address.  We concluded that there may be more precise and economical solutions.

 

Problem:  Imprecision and Inefficiency of GDP-Linked Investment Practices (or of any index chosen)

Opportunity:  Create effective inflation management tools that assure real inflation adjusted returns and benefits for all stakeholders.

 

We propose the following:

- START with REAL desired return,

 -select GDP or mutually agreed more precise Inflation measurement to apply over time,

- then calculate the equivalent nominal units needed to continuously pay and receive a constant purchasing power.  

 

We know the present value, but not future value after the effect of inflation over time.   Starting in REAL allows us to know the stable/known value of a future payment/receipt.

 

Indexed bonds ably address significant elements of the problem.   Linkers and TIPS are well-proven tools.  However, Linkers lag and do not use a cross product calculation to solve this lag.   TIPS are effective in tax-advantaged accounts but introduce certain tax inefficiencies. 

 

We need to make more efficient our retirement, endowment, annuity, or life policy by adding a stable/known purchasing power asset class.  We can do this by employing a patented simple yet profound structural change.

 

We chose to consider the challenge by studying from a new perspective.  Instead of the variable in the calculation being the real return, make it the nominal return.

 

The most critical element to a lender is what the loan will return over the term in real purchasing power.  Why use this as the variable?  The most critical elements for a borrower are the cost and the effect of the debt on the balance sheet.  Through a creative recasting of the assumptions underlying the amortization schedule, we can improve upon both in comparison with the current method.

 

If, as in the current model we have the real return as the variable, we make assumptions about what we suppose inflation to be for the period.  The actual real return will be too low if we assume too little inflation, so we must make generous assumptions about what inflation may be.  This introduces guesswork and imprecision, resulting in product pricing higher than would otherwise be the case necessary to ensure the desired return.  It is of course passed on to the customers.  But, any issuer having the ability to charge lower initial rates, while assuring its real return, will have a strong competitive advantage.  Inasmuch as this inefficiency runs through the entire capital formation market, efficiencies introduced in products will result in benefits throughout.

 

The debt accretion that Linkers and TIPS impose on the balance sheet is of concern to the borrower.  The affordability of Linkers and TIPS, particularly in the early stages of the debt before the growth implied by the additional funds has occurred is also of concern.  The current model increases the difficulty of engineering such borrowing at a prudent and mutually beneficial market clearing price.

 

Our proposed model will benefit both the lender and borrower.   It will provide the basis for a robust and efficient derivatives market.  It will provide for a usury-free structure that would appeal to the burgeoning Islamic market.  It will be compliant to all existing rules, regulations, and tax directives.   It will substantially improve the efficiency of a portfolio not only thorough price efficiency, but through insulation from inflation in excess of seemingly prudent assumptions.  Importantly, it will improve the credit scoring of both the borrower and the lender.  All of this leads to materially decreased systemic risks.

 

We understood that we were working on a challenging goal.   Our solution requires that the capital market replace one of the oldest financial paradigms.  Lenders now know the present value of assets and then add inflation insurance in the form of higher rates to their required real return rate.  We intend that they instead use their required real return as the base assumption, then add mutually agreed inflation adjustments at agreed intervals based upon an agreed inflation index.  The result is assured return for the lender with competitive pricing advantages as well as lowered default exposure.  The borrower enjoys lower initial borrowing costs and less chance of default.  Borrowing costs in nominal units will increase with inflation but will tend to do so in line with cash flow growth achieved from the having lowered costs, matching of known real payments to expected real incomes, and deliver stronger balance sheets for all participants in the transaction.

 

There are few times in the market when an opportunity for a new application technology can be incorporated into the practice of capital formation.  One that offers benefits to all parties in an industry is more rare. 

 

We have previously presented to the U.S. Department of the Treasury, the UK Debt Management Office, a member of the Capital Markets Authority of Saudi Arabia, investment houses, insurance companies, actuaries, exchanges, mortgage bankers/lenders, municipalities, endowments, blockchain developers, those with interest in social finance and consumer protection.

 

All agreed that we were correct in our math. All agreed that we were correct that our structure would do what we said it would.  We repeatedly heard ‘not invented here’, ‘not the way we do things’, and/or ‘we have no political cover for being first’.   We heard one member of the group from the UK Debt Management Office say that ‘this is so simple, it must be wrong’; and challenge us to get the first issuance into the marketplace, because if we were correct, there is no other means to find the lowest cost of funding for a sovereign.

 

We heard a very respected economist make a first reaction comment after he heard a brief description of what we were working on, ‘This could be the paradigm shift we all have been looking for.’

 

Our market penetration has accordingly been nil.  Although our structure is in fact relatively simple, the inertia of the use of current imbedded understandings and methods clearly makes embracing our structure a stretch.  The advantages are clear.  At the same time, the change in approach is fundamental.  We believe that for the first time our structure will put the horse before the cart.  The world is accustomed to the less efficient model and averse to change.

 

We have always made our spreadsheets public. No hidden formulas or calculations.  Open for one to modify the spreadsheets to their specific needs.  Some did not want them, because they were working on their own methods and did not want to possibly cross ours.  We understand that.  But we don’t believe anyone has attempted to bring a similar, competing, or lower cost of risk management to the publics’ attention.

 

What is the means to work with the marketplace, to pay for performance and have the method challenged and vetted that we have so clearly missed?

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