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Is Debt Really an appropriate Financial Instrument for the 21 st Century? Evan Schulman Tykye, LLC Summer 2012.

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Presentation on theme: "Is Debt Really an appropriate Financial Instrument for the 21 st Century? Evan Schulman Tykye, LLC Summer 2012."— Presentation transcript:

1 Is Debt Really an appropriate Financial Instrument for the 21 st Century? Evan Schulman Tykye, LLC Summer 2012

2 Proposal  US Government Sells: “x”% of GDP for, say, 20 or 30 years  “x”% is the amount raised / Present Value of GDP  Certificates expire worthless  There is no guarantee of principal With no guarantee, Certificates are not debt  Gilbert v Comm’r (2d Cir. 1969) For tax purposes Certificates are annuities

3 Beneficiaries  Legislators: Debt ceiling goes away - temporarily  Voters: Certificates are self-liquidating  We pay our own way; no longer saddling our progeny with our debts  Treasury: No rollover requirement Decreases debt service burden in recession  The debt service relief can be used for tax decreases or stimulus projects  Investors: A marketable, no-load, no fee term annuity with growth, inflation protection, low volatility (vs equity) and no counter-party risk - that covers the economy  Buy America (GDP = f(inflation, productivity, population]) vs TIPS  Intermediaries may disaggregate, allowing tailored sector exposure Spreadsheet

4 Spreadsheet Results  Retire 10% of Treasury Debt: ($1.6 Trillion) Assume: 3% nominal growth, 30 year maturity Given today’s Treasury rates of 2%, Govt needs to pay 0.3% of GDP of which principal is some $20 billion  Adjust for “equity” risk Equity risk Premium = 4%, beta = 0.1 Investors’ required rate goes from approx 2 to some 2.5%  Value Inflation Premium “Unexpected inflation” starts in year 5 at 1.5% Premium approximates 13% or some $180 billion

5 Corporate Debt: Limitations  Saddles Issuer with Fixed Costs  Exposes Investor to the risks of Inflation  Low Placement Agent Fees Net of customization expenses  Illiquid Secondary Market Transaction costs are large relative to the small changes in credit and the value of imbedded options & seller may have information

6 Sales Certificate A contract like a bond, but ….  Payout = a function of gross revenues (sales)  Expires worthless at maturity  Standardized terms Terms are reset in case of merger or acquisition  This instrument is currently in use  Consequences: risk shifts for issuer & investor Tax on crime, non-usurious,

7 Issuer Benefit  Fixed cost becomes a variable cost Self Adjusting costs make these a Premium Product  The “interest” equivalent is tax deductible Ernst & Young letter  Smaller liquidity premium Changes in revenue prospects will swamp transactions costs versus the small changes in credit ratings and valuations of imbedded options of bonds Sales are transparent

8 Investor Benefits  In periods of inflation stocks & bonds are highly correlated Certificates are hooked to sales & behave differently Inflation insurance is important for both defined benefit & defined contribution plans & NOW is the time.  High Cash Flow Vehicle  No-load, no-fee, marketable Term Annuity with inflation protection  More liquidity More transparent; higher probability of informed participation

9 Percent of Sales to Service Issue 5 6 7 8 9 10 11 12 13 14 15 % of Sales = $ Raised/PV Sales Capital raised = ¼ Current Sales 6% Discount Rate Std Dev of growth rates = 8% 5% Growth 0% Growth

10 Potential Purchasers  Those who need an Inflation Adjusted Annuity High Cash Flow Vehicle with inflation insurance  Tailored protection New Asset Class  Investors such as Endowments, Casualty Insurers, Pension Funds Institutions with 401(k) clients  Fidelity, Vanguard, Schwab  Entities under Shari’ah Law Sovereign Wealth Funds

11 Potential Issuers  Money Managers Other Professional Organizations  Auditors (WSJ, Mar 12th 2007 pg A8), lawyers, software firms, consultants: firms with few assets but high margins, Co-operatives  Private Firms, LBOs, Insurance Cos (AIG), Airlines  Firms under Shari’ah law  Firms financing stock repurchase programs Chevron – Market Value / Sales = 1. So, 0.75% of sales redeems 10%+ of equity: - Self-liquidating equity 1/3 rd of listed firms have a Market Value / Sales ratio =< 1.0

12 Inflation Alphas Cohn, Polk, Vuolteenaho: NBER Working Paper 11018 2005 Plus term-structure steepness

13 Issuer Games  Move sales to out years Indenture statement & IRS rules  Concentrate on profitability Indenture statement as to use of funds  Buy less profitable firms?  Over-estimate sales growth of acquisitions ( Under-estimate sales growth of a division sold) Statement “…these are the material facts as we know them…” plus fair value opinion

14 Problems Mitigated: - Corporate Debt  Mitigation: Saddles Issuer with Fixed Costs  Certificates offer self adjusting cost Exposes Investor to the risks of Inflation  Portfolios of Certificates allow tailored coverage Illiquid Secondary Market  Duration changes, need to trade or ladder: like bonds  Speculators attracted by sales volatility Low Underwriter Fees  Premium product

15 Summary  Modigliani-Miller still holds Risks are reallocated more appropriately Premium product, broader appeal  New asset class, new types of issuers  Helps to complete the market  Liquidity: More transparent; trades on revenue prospects, higher probability of informed participation The unfamiliar need not be implausible…

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