A Purchasing Power Crisis? (With a Dash of Refinancing Opportunity)

Crippling personal debt, bankruptcies, real estate volatility, re-industrialization and pay gains vs. inflation are burdens to businesses, governments and citizens. The cost of retirement, college, health, and homeownership savings/fundings combined with future decumulations are burdens that require prudent handling. The spiraling cost of debt to governments undermines the political machinery upon which stability and order depend. The variability of inflation overarches the risks and management of each. Inflation undermines by its effect. It also undermines by its uncertainty. We propose a more effective and efficient financial instrument. It cannot control inflation. But, it can manage its effects.

Inflation creates a gap between anticipated return and the purchasing power of actual return. An efficient fixed and known stable inflation adjusted return delivered by a non-correlated financial instrument manages this fundamental risk. With such a tool financial planning and risk assessment become matters focused on business risk without the need to add guesses about the effects of eternal monetary policy. A mutually agreed index of the diminution of purchasing power over time must be applied using a methodology that is sure, transparent and simple while respecting the risk of all parties to transaction. Both sides must derive real benefit even if precise parity is not assured. The exercise is one of management, not perfection.

Desired Requirements

1)     An instrument more effective, simple and tax efficient than current financial instruments such as Tips, Linker’s, etc. The instrument must manage the pervasive practice of sovereign printing currency to fund accreted national debt.

2)     The instrument must conform to existing rules, regulations, laws, and clearing. trading, reporting, accounting and business practices.

3)     The instrument must permit all borrowers and lenders to participate with material benefits to both. Pensions, Corporations, individuals, endowments, foundations, asset managers, private debt, ETF’s, exchanges, swaps, derivatives all must find the instrument adaptable to their needs and marketplace. Both sides of every transaction must be able to benefit from the instrument within their spheres. Management of inflation must be accommodated more efficiently than by a mutually agreed guess in respect of the amount and timing of erosion of purchasing power.

4)     The PRINCIPAL and the RETURN (interest in western markets and the ‘shared profits’ in Shari’a) must be paid in Constant Purchasing Power. The able assessment of business risk, not a guess of inflation risk, should determine the winners and losers.

5)     The instrument must support an efficient, simple and innovative structure that will amortize debt. A ladder of maturities can be utilized for customization of customer specific needs in respect of project duration. Business time risk, not management of the accumulation of inflation risk, becomes the proper focus. Overall efficiency is materially improved with benefits accruing surely to both parties.

6)     A mutually agreed index to adjust the nominal payments into constant purchasing power can be a published index or one tailored to a specific market. It must manage inflation risk while reflecting industry specific business cycle variables as well. Both sides will enjoy potential benefit. The focus of a transaction will be on the business risk where it belongs once an appropriate measurement of actual, not projected, inflation is agreed. The cost of the loan will reflect reality, not preloaded and imprecise best guesses.

7)     While the instrument will in many cases minimize the need for complex derivative use, it must also be a potential value-added participant in the financial markets. The current make-up of the fixed-income market has three primary asset classes: the Fixed Nominal, the Variable Nominal and Variable REAL. We therefore have Three potential trades to perform risk management. By adding a FIXED REAL (that everyone can capture the benefits of) we can introduce a FOUR-Legged Stool with SIX potential trades to perform inflation risk management.

REAL RETURN METHODOLOGIES (RRM)

The market is concerned with purchasing power. It knows the nominal interest rate is variable and volatile. It can tell the price of everything, but the value of nothing. By fixing the core elements of financing in real, rather than nominal terms, REAL RETURN METHODOLOGIES (RRM) provides an efficient tool that reduces risk for both lenders and borrowers. It lowers costs and risks for both.

Current instruments tend to shift the risk inflation. Ours reduces the effect of purchasing power loss. Others tend to assume a zero sum in respect of risk reduction accruing to both parties. Our method directly addresses inflation for both parties. It also reduces interest rate risk for due to removing the need to increase interest rate against potential inflation risk. Using our method the interest rate can be efficiently tailored to the business risk without the imprecision and risk of guessing about inflation. In addition, it provides borrowers with an extremely valuable ability to derive much more benefit from the value of borrowed sums by virtue of being able to put a greater portion of the funds to work when most needed early in the cycle. This in turn reduces the default risk to the lender. Perfection is not claimed. Material superiority is.

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Inflation Risk

Inflation risk for lenders:

·        Lender is exposed to inflation risk when they fund future real expenditures (e.g., retirement living expenses) with loans whose terms are fixed in nominal dollars rather than in REAL purchasing power. Nominal pricing ties the transaction to a variable. REAL pricing ties the transaction to the lynchpin of any deal: A return in REAL purchasing power. Which makes business sense?

Inflation risk for borrowers:

·        Borrowers are exposed to inflation risk when they finance real assets (e.g., plant and equipment) with financing whose terms are fixed in nominal dollars rather than purchasing power. The full value of the loan can be applied longer with the overall costs consistent with actual purchasing power diminution and not by the necessarily inflated guesses about future purchasing power.

Interest Rate Risk

The drivers of interest rate risks for lenders and borrowers are the same: Duration and interest-rate volatility; the longer the duration and the greater the volatility of interest rates the greater the interest rate risk. Our method efficiently manages the effect of duration and volatility. The risk premia necessarily applied to the transaction are managed efficiently by lower initial rates. Inflation impacts are applied transparently with adjustments done as necessary through time using actual, not imprecise guesses applied through best guesses. Efficiency is improved with uncertainty managed by the application of real data at intervals, not guesses in advance.

Inflation and Interest Rate Risk Management provided By Amortized RRM financings.

Real liabilities are funded with Real financial assets, creating a match that effectively eliminates their inflation risk.

RRM reduces interest rate risk for both lenders and borrowers by reducing interest rate volatility.

The nominal rate of interest equals the real rate of interest plus the expected inflation rate plus the cross product of the real rate once known and the projected inflation rate as applied in advance without the benefit of the real effect of inflation is known. Real interest rates eliminate the variability created by fluctuations of the expected inflation rate. Therefore, the real interest rate utilized by RRM financing is less volatile than the nominal interest rate utilized by nominal financing. Simply put:

1.      RRM Nominal Rate of Interest = (Index agreed upon × Real Rate agreed upon) + Index agreed upon × Real Rate Agreed upon). Thereby eliminating any delay or lag due to inflationary shocks or publication of index.

2.      RRM Nominal Payment = RRM Purchasing Power Payment times the Inflation Factor

The lower volatility of real interest rates stimulates a further reduction in interest rate risks by:

·        Making it safe for lenders to accept longer durations.

·        Further reducing interest rate volatility because long-term rates are less volatile than short-term rates; and,

·        Creating a double benefit for borrowers because their interest rate risk is reduced by both longer duration and lower interest rate volatility.

Default Risk

Default risk for lenders and borrowers has three components:

·        Income will be insufficient to cover debt payments.

·        Asset value will be less than the loan balance; and,

·        A balloon or bullet payment cannot be refinanced.

RRM facilitates reduction in default risk by:

·        Matching the constant real payments to the real income produced by the real assets being financed.

·        Matching the fixed real amortization of the loan balance to the real depreciation of the real assets being financed; and,

·        Eliminating balloon or bullet payments by fully amortizing the loan.

SUMMARY

In summary, RRM lowers risk for both lenders and borrowers which:

·        Lowers their costs.

·        Enables both to focus on business risk, not inflation risk while lessening the need to employ complex and sometimes risky derivatives to track and manage inflation, and

·        Enables both to earn higher returns with less risk.

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