Neualtenburg Bonds

Summary

This bill seeks to define the nature of the Neualtenburg Bond, to ensure its worth, return on investment, and cost to the city. If accepted, the changes would be retroactive for existing bonds. Changes include a fixed duration and return, well-defined methods for converting investments to land-use fees, and guarantees in the event of dissolution.


Agenda

The following items require discussion and a vote:

1. Future city fund raising will be done through Neualtenburg Bonds as described below. The par-value-to-nominal ratio, the maturity date, and the rate type can be determined at the time of issue.
   
2. The currency of issued bonds will set to match the nature of the debt. For instance, a simulator purchase (US$1200) will be issued in US$ and a construction project (say L$30,000) will be issued in L$. The goal is to keep the exchange rate from affecting the rate of the bond.
   
3. All future bond holders should be published to prevent conflicts of interest and to promote full transparency of the government.
   
4. Existing debt will be converted to Neualtenburg bonds retroactively.

If existing debt is converted to Neualtenburg bonds:

1. The RA will need to set a maturity date when the city will have to pay off the debt. I recommend 01 Jan 2006. If we don't have the money to pay the bonds off, the city will have to issue a second set of bonds in December to cover the debt. (This is not a pyramid scheme. This is how real cities do it in the real world. Please ask questions now on this if you don't understand. )
   
2. The RA will need to set a par-value-to-nominal ratio. Please take into account the amount of perceived risk at the beginning of the project and the length of the loan (which is a function of the maturity date). I suggest a ratio of 1.12, which means those who invested US$100 would earn US$12 every nine months (assuming a maturity date of 01 Jan 2006). Those in the RA who have invested money (if there are any) should not participate in this vote due to concerns with conflict of interest.

Neualtenburg Bonds

1. par value - I recommend a factor of 1.12 times the purchase price (the nominal) as the par value. Thus if someone purchased US$100 in N-bonds, the par value would be US$112.
   
2. maturity date - The original city bond sales took place on about the 1 Apr 2005, with the first sale on about the 1 Jun 2005. In the future, bonds should mature at six months from the date of issue. In the case of the original bonds, I recommend setting the maturity date at six months from the date of the first land sale. Thus the first bonds would mature on 1 Dec 2005 and all other bonds six months after issue.
   
3. rate type - Bonds should return at a fixed (as opposed to variable) rate.
   
4. coupon dates - Coupon dates should be monthly and coincide with land-use fee due dates such that citizens can use their coupon to pay for land-use fees, otherwise coupons are paid to them in US$ or held in a separate account (by the city bank).
   
5. callability - Bonds will not be callable (meaning the city can not opt to pay them back early).
   
6. puttability - Bonds can not be put in the traditional sense, where a bond holder can demand early repayment from the city. Instead, there will be monthly bond put dates, where a bond holder can have up to their monthly land-use fees (minus the coupon) deducted from the issue price. This will decrease the size of the next coupon and the par value of course.
   
7. convertibility - When bonds are mature they can be transferred to other city securities (currently we have no other securities.
   
8. dissolution - In the event the cooperative ceases to exist, bond holders will be given proportional shares of government-owned land from the sim or sims that the bonds were issued to support.

Example

Ulrika buys US$300 worth of N-bonds. The par value would be US$336 with a term of six months. Coupon dates are every month, so there will be six monthly coupons of US$6. At the end of six months, Ulrika will be paid US$300.

Ulrika decides that she wants to pay for her US$30 land-use fees using her N-bond. After the first month, she receives a US$6 coupon and deducts the maximum allowed US$24 from her bond to cover the fee. Her new nominal, par value, and coupon after the partial call would be US$276, US$303.60, and US$5.52.


Calculations

Par value, P, is equal to the nominal, N, times a factor:

The factor, f, is equal to a monthly return times the number of months left until maturity, n:

The coupon, C, is equal to the the par value minus the nominal divided by the number of months left until maturity:


~Ulrika~

I need to be very clear on this, as it's a great source of confusion. We are not changing a loan, we are defining a loan officially for the first time. The loans have been without formal definition from the beginning. Sudane is currently applying a 6% APR compounded monthly but that was never agreed upon by the lenders nor ratified by the RA. The current loans must be formalized by the RA, which will set the type of loan (exponential or constant), the rate of return, and the maturity date. They may decide to keep them exactly as Sudane had started them.

This is an interesting idea, however it still requires that the RA vote on the existing nature of the loan retroactively. For example, although the type of accruement would be fixed (compounded interest), the RA would still need to agree on a rate of return and the maturity date (the date they convert to bonds). So in a way, it's the same problem. (Yet even then we never agreed upon nor did the RA approve the use of compounded interest for the loans. Is that a bad precedent to set?)

Keep the comments coming. The RA will need as much information as possible to make their decision. This is our first really big issue that also has the potential of being vetoed by the Guild.

~Ulrika~

I spawned a temporary Neualtenburg Bonds wiki thread here. As we decide on changes to the bill in this thread, I'll update the bill in the wiki thread, where we can all easily find it. The goal is to have it completed before the next RA meeting this weekend.

Feel free to suggest changes, especially in the agenda.

~Ulrika~

Why is this being discussed as a bill to the RA? Is this not a matter of finance?

Ok, this is a bit nitpicky, but may I suggest that you leave out the suggestions from the bill? Maybe for example:

par value - The RA shall determine a par value that it deems fair to all parties.

It seems a little inappropriate for one of the original lenders to suggest the interest rate. Especially since because of your stature in the community, suggestions from you tend to have more force behind it than, say, suggestions from me.

---

In fact, since we're throwing out numbers, I would like to suggest a factor of 1.08 for the par value, and a maturity date of February 1st. ( See, how are these numbers more fair than Ulrika's numbers? I dunno, I just pulled them out of my butt! )

Maybe the solution should be more pragmatic, what can the city pay, and when? Maybe issue the original lender 2 different kinds of bonds, one for say 7 months (starting from June), covering half the current debt, and one for 10 months, covering the other half? There's still the issue of the interest rate.

Well, let me just say I'm glad I'm not in the RA.

This is an excellent point Kendra, one which I was going to bring up after we finished drafting the bill (but I'll do it now).

First let me say that clarifying the definition of the AC (Guild) and it's interaction with the RA (Representative Assembly) has been on my mind quite a bit lately. Beyond this bill, it is my top priority. I'd like to approach it in the beginning by finding what problems and ambiguities exist and then having folks (especially Kendra and the current RA) give their thoughts. From there we'll convene a second constitutional convention and hammer out some amendments to the constitution. In the mean time, I thought we could study the interaction between the RA and AC using this bill.

As I see it Kendra, in regards to this Bonds bill the RA will ratify various items in it and then the Guild will have the option to veto some or all of those laws, since this topic concerns finance. When vetoing parts of the law, the Guild can suggest modifications or rewrites to the bill. The RA and AC can go back and forth on this several times before a compromise is reached. Additionally, if the process drags on too long, the AC has the power to call emergency sessions of the RA (daily) if needed (although I'd be conservative with the use of that). This is all defined in the Constitution.

Let me know if you have additional questions.

~Ulrika~

Good suggestion. It has been done.

~Ulrika~

Just a short question for clarification. Ulrika, is your insistence on using the US$ as the "primary currency" in Neualtenburg related to "Neualtenburg as registered non-profit organisation"? I would like to know a bit more about that, since this is all news to me and it should help the RA a lot in deciding things.

The issue of the L$ "fluctuating" is simply a question of trust in SL's economy The L$ is slowly rising to be higher in value than when we bought the private sim, so, while the decision to go with the US$ should not be established based on "L$ market instability". Short-term, it makes sense; long-term, it looks like the L$ will stabilize due to LL's influences in the economy.

They are definitely not related in any way. I'm simply reading up on the topic of incorporation as a nonprofit and will discuss it with the group after I understand how it applies to us. The desire to base the accounting in US$ is simply because our liability is in US$.

In the case of bonds, since they are an investment vehicle, one should base them in either US$ or L$ depending on the nature of the debt that the bonds are to cover. The reason is, that we don't want to inject the instability of the currency market into the investment, especially when the bonds have such meager returns. With the current system, our total accruement is approximately 3%, which is equivalent to a +/- 4 L$/US$ variation in the market. Such fluctuations used to be a daily occurrence on the GOM.

Again, I think it will stabilize but never to the point where the returns on our bonds won't be equivalent to the exchange "noise" and short-term trends. I just want to make sure when folks invest US$100, that they always get back US$100 plus interest, regardless of the exchange rate. Nothing would be more detrimental to the quality of our bonds than investing US$100 and getting US$98 back. That applies to bonds in L$ as well. I mean, we could do that once but that would be the last set of bonds we ever sold.

~Ulrika~

If we dont want to subject ourselved to the instability of the currency market, shouldn't we offer bonds depending on the nature of our *income*? If our income is mainly in L$, it would make more sense that we issue L$ bonds in the future. Even if the expenses are in USD. To protect ourselves from the movement of the currency market, we could sell the L$ at or near the time of the bond's issue.

Here's an example, let's say nburg wants to raise money to buy an island, and pay for 3 months of maintenance for the island, that's maybe about 1800 USD. We can either issue 1800 USD worth of bond, or say a 600,000 L$ bond.

If we issue the USD bond, we will have to deal with problems of privacy (avatars revealing their RL identities), paypal fees and/or the labor costs of writing/cashing checks, and possibly tax issues. What we also have to deal with, if our income is in L$, is that converting our income to USD will subject the city to the vagaries of the currency market.

If we issue the L$ bond, once we raise the cash, all we will have to do is convert *all* the needed L$ to USD and pay the 3.5% fee (assuming we can buy an island from the account balance). Any L$ income from say land transfer taxes, or excess L$ from land use fees, and dwell would then *not* have to be converted to USD to pay for the bonds.

So it seems to me that the proper way to borrow money in the future is to consider where our excess income comes from, either USD or L$, and use that as the currency of the bond.

I see what you're saying and I also think I understand your motivation. It sounds like you're interested in purchasing bonds using L$ for our upcoming sim purchase.

Let's agree upon some terminology first, before we dive in. From the perspective of the city, those who purchase bonds are lenders and the city is a borrower. Thus the money that the city receives is not income, rather it's a loan. So, to restate what you're saying, we should issue bonds in the currency that the lenders prefer.

If we accept L$ investments, the LindeX L$-to-US$ ratio will affect the return. It's imperative that you see this before we continue, as moving forward without understanding how this will happen could upset future investors, cost the city money, and call into question the quality of our bonds.

For a standard US$ to US$ bond transaction we have:

Buy
  Lender -> PayPal -> N'burg -> LL
  US$1035   US$1035   US$1000   US$1000
  F         f         C         C

  F = C (1 + f)

  The total fees needed, F, is equal to the cost of the server, C,
  times 1 plus the PayPal fee, f.

Sell
  N'burg -> Par Value -> Lender
  US$1035   US$1138      US$1138
  F         p            N

  N = F (1 + p)

  The total amount due to the lender, N, is equal to the total
  fees borrowed, F, times 1 plus the return, p.

Total Cost
  N = C (1 + f)(1 + p)

  K = N-C = C (f + p + fp)

  The total cost of the loan, K, is the cost of the server, C,
  times the sum of the PayPal fee, f, the return, p, and the
  product of the PayPal fee and return.

However, for a L$ to US$ bond transaction that is paid off in L$ we have:

Buy
  Lender -> LindeX -> LindeX -> N'burg -> LL
  L$310.5k  L$310.5k  US$1035   US$1000   US$1000
  F'        r0        f         C         C

  F' = r0 C (1 + f)

  The total fees in L$ needed, F', is equal to the cost of the server, C,
  times 1 plus the PayPal fee, f, times the exchange rate, r0.

Sell
  N'burg -> Par Value -> Lender
  L$310.5k  L$341.55k    L$341.55k
  F"        p            N'

  N' = F" (1 + p)

  The total amount due to the lender in L$, N', is equal to the total
  fees collected, F", times 1 plus the return, p.

  Note that while F' and F" are equal in L$, they have different
  values in US$!  Because the city's revenue is pegged to the US$,
  the amount (and value) of the L$ we collect monthly varies.
  Thus the value of the fees collected in US$, N, is a function
  of the exchange rate at the time of the collection.

  In fact its value is a sum of the fractional collection,
  a_n N', divided by the exchange rate, r_n, at the time of payment:

                                                       n
  N = a_0/r_0 N' + a_1/r_1 N' + ... + a_n/r_n N' = N' Sum a_k/r_k
                                                      k=0

  Yuk.  Let's ditch the summation by assuming there was single
  transaction that converted all currency at once:

  N = N' / r1

  Then we get:

  N  = F"/r1 (1 + p)


Option
  Substituting like the previous example and converting to US$
  to solve for the total cost one finds:

  K' = N-C = C [ r0/r1 (1 + f + p + fp) - 1]

  Which is different than the previous example.  The difference
  between these costs is:

  K' - K = C (r0/r1 - 1)(1 + f + p + fp)

(Don't forget to scroll the above window down to see all the math.)

As you can see the cost to the city is a function of the ratio of the exchange rates. If one updates the equation to include the summation, calculating the true cost becomes quite difficult. A solution to this is to reference the bonds to the US$, when paying them back, however when we do that, the par value, p, will fluctuate by the ratios of the exchange rates, meaning that the volatility of the currency market is injected into the bond return. Lenders could see returns less than their investments!

*Whew* Sorry for the math. I'm just trying to show others what I see in my head when we discuss this.

It is my opinion that we can allow this kind of debenture but that it should not be called a Neualtenburg Bond. We should create a second type of debenture that allows for currency fluctuations with the risk placed on the lender in a second separate bill that we can draft later.

Would that be a good compromise?

~Ulrika~

Hi, I'll look at the math later, but I think there's a misunderstanding here...



This is true.



There is no question that I would prefer to purchase L$ bonds. However, what I meant by income is not the money that the city receives from the lenders, but the money the city receives from taxes. Currently, as I see it, the city gets revenue from these sources:

1. Sale of land
2. Land use fees
3. Land transfer tax

Now, any of these may be paid either in US$ or L$. However, our monthly costs are in USD. My understanding is that only enough L$ is converted to USD to cover the monthly expenses, and the rest of the L$ is kept as L$.

This means our *surplus* is kept mostly in L$. This is what I mean by income. If this is the case, it seems to me that bonds ought to be issued in L$. So no, I wasnt trying to make the case that "we should issue bonds in the currency that the lenders prefer." ( although there is a case for that as well

First of all, thanks for being so patient. This is definitely a difficult topic.

I believe that you are correct that our surplus money is kept in L$. Thinking the same thing, I had a proposal a few weeks back asking to convert all the city's L$ holdings to US$ while the US$-to-L$ was dropping. By the time the proposal made it to the RA the exchange bottomed out and everyone agreed to sit on our holdings.

In regards to the surplus, this is actually discussed in the mathematics above (the surplus is represented by a summation that is later simplified). By equating this surplus to an equivalent value in the same currency as the purchased item (a sim), one can derive the most important metric, namely, what is the cost of the loan to the city. It can be seen in the math, that the cost is simply the money taken in minus the money paid back in the same currency. To show that there is a difference in the cost to the city between the two methods I derived the cost using the single-currency method and the cross-currency method and showed that the difference in cost between the two methods is a function of the ratio of the exchange rates.

It'll take some time to step through the math but I think you'll see that the true cost does change because the value and amount of L$ we collect every month changes.

Recall yesterday when you were stating that the city should seek to minimize its cost and even suggested (as an example) shaving a few percentage points off my suggested par-value-to-nominal ratio. Here one could apply a similar argument, in that the city should be careful about cross-currency loans because the exchange rate can increase the cost of the loan. This includes the case where one collects surplus in L$. The difference in cost between the two methods is:

K' - K = C (r0/r1 - 1)(1 + f + p + fp)


The problem with me is that I see mathematics everywhere. I understood that cross-currency finance management is dangerous instinctively. For instance, we just converted the accounting over to US$ with a floating monthly L$ fee because the city was coming up 25% short on payments which are due in US$. I'm trying to make sure that this same cross-currency snafu doesn't bite us (or our investors) again in the future. I'm all for cross-currency bonds as long as the lender understands and takes the risk.

~Ulrika~

My head a splode.

I'm really struggling through the math, I think those arrrows confuddle me. That is, the dollar values and the variables labeled under them are not the same.

Anyway, if I understand the math right, I think what I was pointing out, and what is missing in the equations for US$ to US$ bond transactions is that there is a cost associated with converting L$ tax revenues to USD.

And what I forgot was that the monthly land use fees varies together the exchange rate; thus the city could be in trouble if it borrowed money in lindens when the L$ value was low, and had to pay when the L$ value was high with respect to the dollar. (this can be mitigated somewhat by issuing new bonds, or issuing them at regular intervals, unless the L$ is in a long-term uptrend).

Speaking purely as a potential buyer of the city's bonds, if I paid L$100k for a bond with a factor of 1.12, I would expect to get back L$112k. If the bond's value varied together with the exchange rate, that would be a much less appealing investment.

As for what is best for the city, I dont know. Maybe that's a discussion for when we actually need to issue a next set of bonds -- maybe at that time it would be 6USD/1kL$, then I'd have a better case for the city issuing L$ bonds with fixed interest .

Sorry about that. The data is organized in columns and the arrows show the flow of money. I used these flow charts as a way to visualize the equations underneath the columns.

.
  Lender -> PayPal -> N'burg -> LL
  US$1035   US$1035   US$1000   US$1000
  F         f         C         C

  F = C (1 + f)

1. The Lender starts out with a sum of money called "F", for example US$1035.
   
2. The Lender then pays PayPal, which charges a fee "f".
   
3. N'burg then receives the money minus the fee, called "C".
   
4. N'burg then pays Linden Labs for a server (set to US$1000 for simplicity).

The equation represents this flow of money.

Yes. A rule of thumb is that all cross-currency investments and debts will have the exchange rate reflected therein. Depending on what the city sets as a reference, this variation can either be absorbed by the city or the individual.

Just two weeks ago, we used the L$ as our currency reference. As the value of the L$ dropped, the city saw a 25% shortfall in revenue. We just passed a bill which locked the land-use fee to the US$ to keep city revenue constant, requiring a floating L$ value for land. The goal of this bill is to make sure we don't run into the same problem with our bonds. Imagine investors receiving 25% less than they invested.

It's important to lay the foundation for the Bonds now, as we currently have investments that have are undefined and expansion is just around the corner. Oktoberfest and the holidays will fly by, leaving us in January when planning and fund raising for the next sim will begin.

That's my pitch. How did I do?

~Ulrika~

I think if the investor invested in L$, his own frame of reference will be L$, that is if he invested 100K$L, he'll expect 100K$L + interest back. If the dollar value of the $L halved in the meantime, it was a risk he willingly took, since he knew the exchange rate is volatile.

From the city's perspective though, a L$ bond is good if the L$ value decreased with respect to the dollar between the time the bond was issued and the time it matures. Because the city's revenues are tied to the exchange rate, decreasing L$ values means more L$ revenues, making it much easier for the city to repay the loan.

Of course if the L$ value increased, this is bad for the city wrt paying the loan.



I just think determining the currency the bond will be issued in right now might be overly restrictive. For example, if the exchange rate were $6USD/1k$L, it makes a lot of sense to issue L$ bonds even if the expenses were in USD. (I dont have to reiterate that I *do* have some vested interest in seeing nburg issuing L$ bonds, do I?

But yes, laying down guidelines to how the city should take out its next loan is very important -- we at least need to ensure that the next loan isnt as ill-defined as the last one.

Exactly! One final note, is that in terms of an investment, if the change in the exchange rate is greater than or equal to the return on the bond, then it is no longer a bond investment, it is currency speculation.

Therein lies my greatest concern. If we sell cross-currency debentures, what looks like a nice, safe bond, in fact becomes nothing more than currency speculation. We would be selling a wolf in sheep's clothing.

I agree. Let's not lock ourselves in. I think if folks want to have cross-currency investments, that they should be allowed to.

However, as you can see from my argument above, I'm not likely to support cross-currency investments unless they are clearly labeled. So, as a compromise, what do you think about amending the bill to include two types of bonds? One will be a common-currency Neualtenburg bond and the other will be a cross-currency Neualtenburg bond. The cross currency-bond will have a stipulation in it that the par value will be scaled by the ratio of the exchange rates for all coupon issues and on the call date, meaning currency fluctuations are the responsibility of the investor and not the city. What do you think?

~Ulrika~

This is a good compromise, it allows people who wish to deal only in L$ to invest. It will also allow people who do not wish to divulge their RL identity to invest. I guess I will have to look for a stable return on investment (from a $L frame of reference) elsewhere.

Ulrika, I think I finally understood your argument -- not from the maths, lol, I won't pretend that I understood them fully but from one of your explanations: bonds should be tied to the same denomination as land usage fees, since that's the largest income source Neualtenburg has. That, at least, makes sense to me

Also, it seems that we are now discussing the other side of the equation (pun intended!). We started to get worried because the L$ was dropping and investors would be losing money; now we're worried because the L$ is rising, so, the City will lose money when repaying bonds (if they're fixed in L$).

It seems reasonable that, if we have bonds, they're either in US$ (less risk) or L$ (more risk, both to the city and the investor). That would mean a different interest rate on both.

Flyingroc, it seems to me that someone investing in L$ is not simply wishing for a return in investment measured as a simple percentage of their base investment -- they'll want to cover other costs as well: inflation (so hard to measure in SL, since we don't have a Consumer Price Index...) and fluctuating currency exchange rates. Dealing with mixed denominations is quite difficult... I remember driving my old RL bank account manager to despair when he had to explain me that I should not invest in funds in US$ -- they would pay out much more than funds in Euros, but I'd lose all the benefits of the higher interest rate due to the US$ endless declining over time (in the end, I opted for both -- the US economy always grows much faster and that usually pays off long-term...). Similar choices will be present for people opting for US$ bonds vs. L$ bonds, I think. Well, we definitely need a good bank account manager to explain that properly to potential investors!