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Why the world needs a new type of bond contract

Sep 19 2016 05:00
Edward Ingram

"WHAT the hell is going on?" 

You might well ask.

The central banks have been lowering interest rates to try to avoid a recession for around two decades. It doesn't help. It "kicks the can down the road", as some commentators say.

In fact, it does a lot more than that.

Businesses no longer want to invest to improve their own businesses and increase their profits that way. Instead, they look at how to increase profits by buying another business on the cheap using borrowed money. There has been a merger and acquisitions frenzy.

Others are sitting on mountains of cash, which cannot be invested in anything worthwhile as the economy stagnates. The prices of investments such as bonds, properties and equities in the stock market are all too high. So they buy their own shares.

Let me make the maths simple: a company with 200 shares in the market paying dividends of $2 per share might buy back 100 of those shares. Now there are 100 shares in the market. The dividend is now $4 per share. There is no increase in company profits. The share price rises; it could double. The directors and other shareholders are very happy.

Economies have also been stagnating because there is so much debt out there - most people are busy paying off their debts or paying interest on them. How did they get into so much debt? Various ways, but try this for one: you cannot build a million homes in a day but central banks can reduce interest rates in a day.

This means that the cost of borrowing tumbles. Everyone can borrow more. House prices rise and everyone now has to borrow more to buy a property. Falling interest rates push up the price of bonds. There is nowhere safe for money.

Central banks cannot lower interest rates much more. They hope the economy will start to grow, so that people can afford the massively higher cost of borrowing when they have to raise interest rates to prevent inflation from taking off.

It is a high stakes gamble, because the price sensitivity of all those properties and bonds and their sensitivity to a small rise in interest rates is very large. People are very nervous. Nervous people save or pay down their debts; they do not spend. The economy stagnates.

Then, when one person from the Federal Reserve Bank in America warns that interest rates need to start rising sooner, the market panics. Shares and bond values tumbled around the world last week. Then another person from the same Federal Reserve Bank said the opposite. All shares rose again, at least in America.

The number of unstable financial situations does not end there. When bonds fall in value China, holding huge amounts of American bonds, is not happy. There are currency instability issues to contend with. Emerging markets see the dollar strengthening as interest rates promise to rise.

All of their high risk (bad idea) dollar-based loans become much more expensive. This is done because the lending contracts are incorrectly designed, doubling monthly repayment costs on domestic debt.

What to do?

This is why people like me and other thinkers are busy trying to re-design the bond and property buying/borrowing contracts. We are questioning why central banks should be given control over interest rates. Free markets would do a much better job. We are asking if the currency markets are correctly structured. It creates huge problems everywhere. What makes them so unstable?

What I have suggested, as a first step, given that interest rates have to rise, is a re-think on how bond contracts are written. The same with housing finance and commercial finance.

What my suggestion amounts to is that holders of bonds and people with debt should be told that if nothing is done, you will suffer huge losses and rising costs. So instead, you will be offered a new contract in which you get a loss now and that is the end of it.

After that, the value of your bonds will be guaranteed and for most people the cost of borrowing will stay within their means. That is the concept. The devil lies in the detail but that can be discussed.

This still leaves us with the need to reform the management system which keeps economies growing (or is supposed to), and we need to reform the currency markets.

PS. I have revisited my last four essays for Fin24 in view of the difficulty with terminology. There is a general lack of understanding about what is needed to create a well-managed economy. The necessary vocabulary is not even in place. I have decided to create the missing vocabulary. I may re-publish those essays using the new vocabulary.

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