Rethinking Equity

Some years ago I was in the Middle East, at a time when Islamic Finance bonds were being heavily promoted and London sought to become a hub in their authorship and distribution to meet the demand of sharia compliant investors. The essential feature of the opposition to usury embodied in Islamic finance is that participations in business should be risk sharing equity participations rather than interest bearing debt. In practice, Islamic banks are no more venture funds than are non Islamic banks, and most Islamic finance products replicate the risk profile of traditional debt by structuring sale and buyback at a higher price deals whereby the lender gets its “interest” and security in the detailed mechanics, timing and pricing of the sale and buy back.
The artificiality of these schemes is considerable, and there is a niche of professional practice that is dedicated to finding the particular legal structure a sharia scholar blessing in order to unlock access to devout or religiously demonstrative investor pools.
As a Western banking lawyer, with a bit of finance theory in my mental furniture, I was always inclined to finding the artificiality and hypocrisy of these schemes somewhat absurd. They ended up being complicated ways of establishing packages of rights and obligation to duplicate secured or unsecured interest bearing debt structures, but with extra complicated drafting.
Indeed I remember getting quite vociferous in my defence of the clarity and internal coherence of the traditional Western values of differentiation of ownership and the lending relationship.
What could be clearer, more elegant, and conducive to clarity of relationship than to draw clear water between the ownership relation and the debt relation? Any asset owner has a clear choice. By virtue of limited liability wrapping, he can give some of it away, allowing his financier to share proportionately in the (limited) risks and rewards of ownership or he can agree a price for the finance, pay the price for the finance, repay the principal and maintain full ownership and (usually) control (debt covenants sometimes muddy this).
In any event, this all takes place against the background of well developed personal bankruptcy and corporate insolvency laws, designed to share losses amongst creditors – codifying pari passu treatment of creditors, enforcing security rights, and regulating the sale of assets and the division amongst creditors and, finally if there is a remainder, creditors.
Clear and consistently applied insolvency laws allow the entire apparatus of capital markets theory to construct models of pricing that allow construction of discount rates from riskless sovereign debt in self-issued currency where longer term liabilities are issued at a risk-free interest rate in the form of sovereign bonds, to riskier bonds with a premium for corporate risk, to equity personal and project debt with its own price of money, and a metric of “riskiness” often derived from past data and market prices to determine relationships between different securities.
This all rather justified the often somewhat snitty high handedness of the neo liberal project – risk takers took risks; lenders lent on known terms and lost their money if they lent imprudently; managers who mismanaged lost their ability to borrow; moral hazard backstopped it all and created a hard, but fair world, allowing the talented to demonstrate not only economic acumen, but a rather admirable moral courage in successfully navigating the shoals of hazard, and justifying sometimes outsize reward. It may not have been hard, or taken much effort, but it really was risky.
Then came the banking crisis.
The insolvency waterfall was turned upside down; in an enormous entrenchment of the assets of the old against the young, savers were protected from the insolvency of their banks worldwide, in the UK far in excess of the statutory guarantee afforded them; the government acted as lender and buyer of last resort, replacing a defunct interbank market. The chaotic and far reaching collapse that would have seen an enormous asset transfer to the young on the back of the forced sale of assets was forestalled, at the cost of the collapse of the entire assumption set that preceded it. Prices became political constructs; not only banks were saved, but automakers were rescued from their insolvency. The logic of the risky market was replaced by one of patronage – your firm would be saved from bad decisions of economic tragedy if it had the necessary political importance. The price of money became cheaper and cheaper in an effort to boost lending. Asset prices were duly inflated and remain so. Credit availability took the place of wages growth.
Of course this has led to some peculiar consequences with no very obvious solutions. Indebted nations are more and more required to conform to orthodoxies driven by the very set of assumptions that was overturned by the bail out; uniform understandings of bankruptcy codes blithely ignored pretty important differences between them – for example US home owners are able to give the keys back to their lenders and release themselves from debt not satisfied by the sale on foreclosure – quite different from the UK homeowner, who remains encumbered by the unsatisfied debt after the realisation of the security.
Politicians find themselves hamstrung – unable to lower interest rates/raise asset prices anymore, and with swathes of the population teetering on the brink of insolvency as credit has substituted wages and paltry yielding savings have migrated to rent yielding property bought with loose credit, they can no longer raise interest rates without triggering all the change and upset that inflation would induce.
Yet inflation is nothing more than a transfer of wealth to the young – it equitises the debt by reducing its real value. The older generations were handed their wealth by inflation, but fear to allow their children to benefit from the same mechanism – the longer lifetimes expected by the generation living their retirement have made them fearful of inflation for fear of a long old age with devalued savings unprotected by a strong social net. Yet in politically using their demographic weight to maintain their own living standards, they – without malice or awareness – deny their children the opportunity to buy houses and raise children of their own.
Perhaps a bit more risk sharing in the shape of a dose of inflation might gradually eliminate some of the intergenerational inequity that the generation that encouraged their children to borrow have unwittingly imposed on their progeny. And perhaps the risk sharing approach to finance rather than the cold hand of a low inflation debt contract might have a place outside the arcane world of sukuk bonds.
As the legitimacy of the banking industry has been serially eroded by conduct going to the heart of debt pricing such as the manipulation of benchmark interest rates, and even the simplicity of the risk free nature of sovereign bonds has been clouded by novel currencies, where euros unbacked by a consistent fiscus inadvertently make debt forgiveness a mechanism for opaque fiscal transfers in negotiations that push to the limit the political legitimacy of the political constructs backing the currency, it is clear that politics will prevail over the simple charm of finance theory for many years to come.

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