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Saturday, 14 May 2011

Why The GIB Should Be P2P

In this month's Financial World, Michael Mainelli helpfully explains why the Green Investment Bank "supporters get a hard ride from City anlaysts." The problem, he says, is lack of independence from the government, especially since government policy on alternative energy is "capricious".

I like the "slightly subversive" suggestion for an index-linked carbon bond with the coupon set to the government's performance against its green energy targets. Although if the City won't gamble on government policy, we probably shouldn't let the government bet taxpayer money on its own performance either.

However, there is a way to encourage both broad-based retail investment and widespread household commitment to alternative energy without direct government support. Allow individuals to directly finance each other's alternative energy projects via a dedicated channel on any peer-to-peer finance platform - or, indeed, on dedicated peer-to-peer platforms. Credit risk would sit with individual lenders who are able to diversify across many projects and limit the amount allocated to each one, while earning a better return on their surplus cash than bank savings rates. The initial and ongoing capital requirements for each platform operator would be nominal, compared to the £3bn currently being contemplated for the GIB. And the transparency of online P2P platforms would enable easy measurement of the capital dedicated to alternative energy. In effect, the government would be leveraging its subsidies towards feed-in tariffs etc., not by borrowing on its own account through the bond markets, but by attracting surplus personal savings that currently lack a decent return.

As I've previously explained, this would also avoid the primary risks associated with the vertical credit model of existing bond structures, namely:
  1. The separation of lender and borrower, and fragmentation of the original loan note makes it harder to adjust loans when borrowers get into trouble (as highlighted by the 'fraudclosure' and 'forced repurchase' problems in the US also explained in Confessions of a Subprime Lender).
  2. The process of transforming 'maturity' (changing the date when loans or debt instruments are due to expire) creates balance sheet risk for the intermediary.
  3. It is unclear whether ratings, accounting and audit functions really do remove information asymmetry between borrowers and lenders. Do we have "credible" ratings agencies, when only three dominate the market and they are paid by the issuers of the securities they grade? Similar problems exist in the accounting and audit markets - hence the calls for reforms in these areas.
  4. There are huge challenges for subsequent bondholders to undertake adequate due diligence on large volumes of original loans long since disconnected from the bonds and often not even under the bond issuer's control.
  5. Pressure to reduce the amount of capital required by each operator in the vertical chain of intermediaries results in a game of regulatory, tax, capital and ratings arbitrage that spans the globe and creates endlessly complex corporate structures.
  6. Various factors lead to underestimation of the capital required for the private and implicit public sector guarantees required to support it. This is further complicated by the fact that "...the performance of highly-rated structured securities... in a major liquidity crisis... become highly correlated as all investors and funded institutions are forced to sell high quality assets in order to generate liquidity."
  7. The knowledge that the market can ultimately 'put' problem securities on the taxpayer (whether this is explicit, implicit, direct or indirect) creates a moral hazard that seems to increase in line with the demand for the securities until the system irretrievably melts down.
Horizontal credit intermediation, is a feature of peer-to-peer finance platforms - like Zopa, Ratesetter and Funding Circle - where each borrower's loan amount is provided via many tiny one-to-one loans from many different lenders at inception.

The one-to-one legal relationship between borrower and lender/loan owner is maintained for the life of the loan via the same loan origination and servicing platform (with a back-up available), allowing for ready enforcement. The intermediary has no balance sheet risk, and therefore no temptation to engage in regulatory, tax or other arbitrage. Loan maturities do not need to be altered to achieve diversification across different loans, loan terms and borrowers. The basis of the original underwriting decision remains transparent and available as the basis for assessing the performance of the loan against its grade, as well as for pricing the loan on any resale or refinance, making due diligence by subsequent owners easy. To the extent that credit risk were to concentrate on certain borrowers or types of borrowers, those risks would remain visible throughout the life of the loan, rather than rendered opaque through fragmentation, re-packaging and re-grading. Similarly, the transparency of the initial underwriting and subsequent loan performance removes the scope for moral hazard.

Image from Carnation Canada.
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