The largest flows of capital are now in derivatives. Over $1.5 trillion per day are transacted by one market player alone. In a week, more value than the GDP’s of most of the world’s economies changes hands.
Derivatives are typically loans backed by some collateral. You could, for example, borrow money to buy a house, watch the value of the house increase, sell it, and repay the money. If you're lucky you can see money appear from thin air. All you need is the right collateral.
Enter patents. As David Martin says,
Traditional asset backed finance collateralizations (CMO and CDO products chief among them) are losing their arbitrage attraction as more market participants increasingly compete for capitated deal volume. Therefore, natural market forces will lead to integrating non-traditional products including intangible property products.
CDO is a "collateralized debt obligation", an investment-grade security backed by a pool of bonds, loans and other assets. A CMO is a collateralized mortgage obligation. These have traditionally backed the derivatives market, but are costing more, as everyone wants to get into the game. So people are turning to intangible property products, namely those lovingly-collected patent portfolios.
But, from January 2008, this rosy picture is about to hit a traffic bump:
In 2008, all banks and financial institutions will have to test their loss reserves for their exposure to “intangible economy risks” under the Basel II Accords.
This means, people are borrowing extensively on patent portfolios, and using that money to speculate in the market. Banks have entered into these derivative contracts believing that the patents were worth something. But the idea that patents are valuable is a myth, as Martin explains:
The same professionals who were responsible experts for the recent patent donation tax abuses in the U.S. have carried their valuation practices into modern corporate and equity valuation models. Unfortunately, their methodologies … cannot be substantiated across all industries or participant groups… They have developed elegant models that allow certain companies and their patent holdings to regress to an ideal condition. However, outside of these selective occurrences of “best fit”, the evidence points to countless more enterprises where they same criteria do not indicate value accretion at all.
In other words, patent valuations are mostly not based on real evidence but on marketing. Martin backs-up this analysis by pointing out that:
In the long-anticipated market attempts at patent insurance, the only profitable line of commercial IP insurance has managed to operate by the exclusion of adverse risk (in other words, rejecting as uninsurable) found in most patents and patent holders.
No-one is willing to insure patent value. Yet banks are willing to lend large amounts money to people who have only patent portfolios as collateral. This seems a little naive. And banks that naively take on large amounts of debt tend to be punished by the market at some point. David Martin believes that point is early 2008, when a new set of regulations called "Basel II" come into force:
Beginning in January 2008, all global financial institutions and their credit customers will be faced with the untenable position of having to report the risks posed by intangibles.
Some banks have started to implement Basel II:
Among the first banks already confronting this pre-Basel II challenge in significant and reported manner is Credit Suisse First Boston who, over the last 2 quarters of 2006 and the first quarter of 2007 has already taking significant charges on sub-performing credits.
David Martin sees this as a good business opportunity, "that the greatest finance business opportunity before us is the convergence of a capital market “perfect storm” in about 2008." As it's been said, the time to buy is when there is blood in the streets.
What does this mean for the patent system? David Martin points out that three separate bubbles are about to pop at the same time: consumer debt, mortgage debt, and patent debt. Each of these bubbles will cause enormous damage to those institutions who were over-committed, and most certainly to those who helped create the bubble. The patent offices will not go unrewarded for helping to create another Great Depression, by printing trillions of Euro worth of funny money.