Smart Money

Copyright © 2015 by Andrew Palmer

Published by Basic Books,

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Designed by Cynthia Young

Library of Congress Cataloging-in-Publication Data

Palmer, Andrew, 1970–

Smart money : how high-stakes financial innovation is reshaping our world-for the better / Andrew Palmer.

pages cm

Includes bibliographical references and index.

ISBN 978-0-465-06472-4 (hardback) — ISBN 978-0-465-04059-9 (e-book) 1. Banks and banking—Technological innovations. 2. Finance—Technological innovations. I. Title.

HG1709.P35 2015

332.1­—dc23

2014041326

10 9 8 7 6 5 4 3 2 1

For Julia, Eliza, Joe, and Kasia

Contents

Preface

PART I: LESSONS BADLY LEARNED

1. Handmaid to History

2. From Breakthrough to Meltdown

3. The Most Dangerous Asset in the World

PART II: A FORCE FOR GOOD

4. Social-Impact Bonds and the Shrinking of the State

5. Live Long and Prosper

6. Equity and the License to Dream

7. Peer-to-Peer Lending and the Flaws of Finance

8. The Edge: Reaching the Marginal Borrower

9. Tail Risk: Pricing the Probability of Mayhem

Conclusion

Acknowledgments

Glossary

Notes

Index

Preface

When I was offered the job of the Economist's banking correspondent in the early summer of 2007, my reaction was one of apprehension. Banking was not an industry that I knew anything about. I had a bank account and a mortgage, knew a couple of friends who had gone into the industry and owned much bigger houses than mine, and that was about it. Grappling with the ins and outs of bond markets and bank balance sheets was not just going to be unfamiliar ground—I assumed that it was also going to be boring as hell.

As far as I was concerned, this was an industry that remorselessly piled up profits. The previous few years had seen an epic expansion of bank returns. The largest one thousand banks in the world reported aggregate pretax profits of almost $800 billion in fiscal year 2007–2008, almost 150 percent higher than in 2000–2001. Banking boasted the largest profit pool in the world in 2006, according to McKinsey, a consulting firm, at 11 percent of the global total.

My professional life was about to consist of interviewing people who made money hand over fist and would presumably continue to do so for as long as I wrote about them. They might be greedy, they might be arrogant, but they certainly knew what they were doing. I didn't realize it at the time, but I was already thinking like a financial regulator.

Fears of a life of tedium turned out to be a bit misplaced. I started on the banking beat in September 2007. The summer had already seen large parts of the financial markets take fright. The downturn in America's subprime-mortgage market had made it impossible for investors to value their holdings of securities backed by these types of loans. The interbank markets, where banks loan money to each other, had suddenly seized up, as institutions realized that they could not be sure of the standing of their counterparties. Something unexpected was happening to the moneymaking machine.

My very first week in the job coincided with a deposit run at Northern Rock, a British lender that came unstuck when it could no longer fund itself in the markets. Some of my earliest interviews on the beat were with people dusting off the manual on how to deal with bank runs. Organizing guide ropes inside bank branches was one tactic: better that than have people spill out onto the street, signaling to others that they should join the line. One HSBC veteran happily recounted stories of the financial crisis that gripped Asia in the late 1990s, when tellers were instructed to bring piles of cash into view to reassure people that banks were overflowing with money.

Tales of improvisation from Asia were not supposed to be relevant to the West's ultrasophisticated financial system. But far worse was to come. A chain of events was under way that would lead in time to the collapse of Lehman Brothers, a huge US investment bank, state takeovers of swaths of the rich world's banking systems, a deep global recession, and the Eurozone debt crisis. I observed these later phases of the crisis from the position of the Economist's finance editor, a post that I held from July 2009 until October 2013.

The crisis would lead to a complete reversal in public attitudes toward the financial industry. The decade leading up to the crisis was one in which finance was lionized. Policy makers applauded the march of new techniques, such as securitization, that appeared to send risk away from the banks and spread it more evenly throughout the financial system. Belief in the efficiency of markets was so pervasive that the skeptics were both few in number and easily dismissed.

The events of the past few years have shattered the belief of outsiders in finance's infallibility. That is an entirely good thing. The system is far less Darwinian than the bankers would like to believe. Banking is not the only industry that gets government handouts—in October 2013 the US government booked a loss on the $50 billion bailout of General Motors, and I don't see much public discussion of the evils of the car industry—but it has clearly benefited from a safety net that others do not have. Nor is it really the law of the jungle for individuals in banking. I have met a lot of very bright people in the financial industry, but I have also met some very mediocre ones, and pretty much all of them seem to remain employable.

But when things go so badly wrong, the pendulum almost inevitably swings too far in the other direction. Another type of consensus has emerged, one in which finance is demonized, in which bankers are generally bad, in which there is a "socially useful" bit of the industry that doles out loans to individuals and businesses, and the rest of it is dangerous, unnecessary gambling. Such anger is understandable. But it also has the effect of distorting the public view of the industry.

***

CHRIS SHEPARD IS THE kind of person that people have in mind when they lament the pull of finance for society's brightest minds. The youthful American used to wear a lab coat working for ­Genentech, a biotechnology company whose stated mission is to "develop drugs to address significant unmet medical needs." You don't get much more noble than that. Yet Shepard turned his back on the bench, first for a master of business administration (MBA) and a spell in management consulting and then for the world of high finance. His conversation is peppered with references to equity tranches and bond coupons, balance-sheet volatility and payment triggers.

Shepard founded a venture called Structured Bioequity (SBE). The problem he was trying to address is the harm that can be done to a small biotech firm if one of its drugs fails during clinical trials. Clinical trials are designed to gradually widen the pool of people that a new drug is tested on, and their results are very unpredictable. About 85 percent of therapies fail in early clinical trials. Shepard was particularly focused on the risks involved in Phase II trials, when tests move from a very small group of human guinea pigs to a larger one.1

For a very big pharmaceutical firm, with deep pockets and a fatter pipeline of new drugs, a failed trial need not be the end of the road; it can write another check in order to keep development teams together. For smaller firms, which often have no more than two or three drugs in the queue, the damage caused by an unsuccessful clinical trial can be terminal. If the lead drug of one of these firms fails, the entire value of the company can be lost, and it may well fold. The knowledge gained from working on a particular drug scatters, along with the chances of a better outcome the next time around.

Shepard's idea works like an insurance policy. Investors in effect indemnify the firm against a failed clinical trial, promising to pay out an agreed amount in that event so that the firm can rebuild its portfolio. In return, SBE offers the chance for investors to participate in the upside of a successful drug, by turning the amount indemnified into an equity stake in the company upon successful completion of clinical trials. By including enough drugs in the portfolio that is being protected, Shepard thinks that investors can be reasonably confident that some medicines will make it to market. And that in turn should mean that promising medical research is not lost when a particular avenue is closed off.

Progress in getting the first investors to bite was slow, as is typical for an entirely new idea, but when I met him in 2013, Shepard was determined to keep going. Asked why he has turned his back on medical research for finance, he shrugs. "I think I can make more of a difference this way than as a scientist." In the wake of the 2007–2008 crisis, that has become an arresting statement to make.

Two broad misconceptions have taken hold as a result of the convulsions of recent years. The first is that if only finance could turn back the clock, all would be well. Banks never used to run with such low levels of equity funding—the money that shareholders put in and that gets wiped out when banks sustain losses. The securitization markets, where a lot of different income-producing assets such as mortgages get bundled together into a single instrument, never used to be so complex. Stock exchanges never used to be the plaything of algorithms. The temptation is to try to identify a point in financial history when everything worked better and get back to that point. The meme that banking should be boring is widespread. Elizabeth Warren, a Democratic senator from Massachusetts, has used this very phrase to promote a bill that would separate American banks into their comfortingly familiar retail businesses (the ones we all use as customers for checking accounts, mortgages, and the like) and their exotic capital-market businesses (where firms raise money and manage risks).

Yet turning back the clock, as well as being impractical, is no answer. The greatest danger often lurks in the most familiar parts of the financial system. Deposits are seen as a "good" source of funding, even though they can be taken out in an instant and get a giant subsidy in the form of deposit insurance. Property is regarded as a bread-and-butter banking activity but is the cause of banking crisis after banking crisis. Secured lending is seen as prudent, even though it can mean decisions are often made on the basis of the collateral being offered (a house, say) rather than the creditworthiness of the borrower (a borrower with no income and no job, say).

If you look at the write-downs recorded during the crisis, where were they found? In investment banks, yes, but also in the retail and commercial banks. The biggest bank failure in US history was that of Washington Mutual, which collapsed in 2008 with $307 billion in assets and a pile of rotting mortgages on its books. The worst quarterly loss was suffered by Wachovia, another "normal" lender: it chalked up a loss of $23.7 billion in the third quarter of 2008 because of loans kept on its balance sheet. Irish and Spanish banks managed to blow themselves up without the assistance of securitization and credit-default swaps (CDS). The thread running through the financial crisis of 2007–2008 was bad information—about the quality of borrowers, about who had exposure to whom, about how a default in one place would affect other loans—and it brought down every type of institution, simple and complex.2

The second misconception concerns the benefits of financial creativity. Few areas of human activity now have a worse image than "financial innovation." The financial crisis of 2007–2008 brought a host of arcane financial processes and products to wider attention. Paul Volcker, one former chairman of the Federal Reserve whose postcrisis reputation remains intact, has implied that no financial innovation of the past twenty-five years matches up to the automatic teller machine in terms of usefulness. Paul Krugman, a Nobel Prize–winning economist-cum-polemicist, has written that it is hard to think of any major recent financial breakthroughs that aided society.3

A conference held by the Economist in New York in late 2013 debated whether talented graduates should head to Google or Goldman Sachs. Vivek Wadhwa, a serial entrepreneur, spoke up for Google; Robert Shiller, another Nobel Prize–winning economist, argued for Goldman. Wadhwa had the easier task. "Would you rather have your children engineering the financial system creating more problems for us or having a chance of saving the world?" he asked. Even an audience of Economist readers in New York was pretty clear about its choice, plumping heavily for Mountain View over Wall Street. Yet Shiller's arguments are the more powerful. "Finance is the place you can make your mark on the world. . . . You cannot do good for the world by yourself," he told the conference. "Most important activities have to have a financial basis."4

This book is divided into two parts. The first is designed to give the reader a broader framework for thinking about financial innovation than just the 2007–2008 crisis and its aftermath. The natural response to the idea of financial ingenuity is to say, "No, thanks." But as the opening chapter demonstrates, the history of human enterprise is also one of financial breakthroughs. The invention of money, the use of derivative contracts, and the creation of stock exchanges were smart responses to fundamental, real-world problems. Financial innovation helped foster trade, smooth risks, create companies, and build infrastructure. The modern world needed finance to come into being.

Without question, the industry did a bad job in the first years of this century of applying itself to big problems. But calling a halt to inventiveness—freezing finance in place, no bright ideas allowed—would not solve the problems associated with the industry. As the second chapter explains, the big risks that finance poses materialize long after the "lightbulb moment." There is a problem with how financial products and markets evolve, but it is a problem that is deeply associated with scale and familiarity, not novelty and creativity.

The third chapter presents a concrete example of how an absence of innovation can be far more damaging than its presence. Property is the world's biggest financial asset and mortgages perhaps the industry's most familiar product. Although people like to think of this as being an area that was taken over by the financial wizards, that is not the right lesson to draw from the crisis. In the United States the industry did come up with inventive ways to pile debt onto inferior borrowers. But in Europe the ordinary mortgage proved just as destructive to many banking systems. Property needs more fresh thinking, not less.

Although there are ingenious people and products in the big institutions, the revolutionary ideas come disproportionately from outsiders. That is common to many industries, not just finance: it takes an unusual firm to blow its own products out of the water; innovation usually comes from new entrants. But the bad habits formed by years of unrestrained profitability seem particularly hard to shake in finance. "When we describe our business, bankers look at us with blank expressions," confides the founder of one financial start-up. "All they can say is: 'But you could be charging more. Why don't you?'"

If the first part of the book makes you doubt that financial innovation is all bad, the second should convince you of its capacity to do good. Despite the crisis—and in some cases because of it—finance is as inventive as it has ever been. The second part looks at some of the efforts being made to resolve an array of enormous social and economic problems.

Many readers of this book will live in countries that need to bring their budgets under control by cutting public spending. Chapter 4 explains how finance can help lure private capital into the gaps left behind. The same readers can also expect to live longer than any generation that has gone before—particularly if people like Chris Shepard can improve drug-development processes. Yet if they are anything like the average citizen, they have far too little saved for their golden years. Chapter 5 looks at some of the industry's initial answers to the downside of longevity.

As dramatically as society is changing, the technological landscape is changing faster still. The Internet is enabling the suppliers and consumers of financing to connect directly rather than via intermediaries. The rise of "big data"—the ability quickly to capture and process huge amounts of information—is improving the way borrowers are screened and risks assessed. At the same time, the crisis has underlined the need for fresh thinking about the way that finance itself operates, so that its worst features (a love of debt, a tendency to forget danger when the going is good) are blunted.

The next four chapters elaborate on both of these themes. Chapter 6 looks at new ways for students to put themselves through school and for new companies to raise early-stage capital. Chapter 7 explores the world of peer-to-peer financing, in which lenders and borrowers bypass the banks altogether. Chapter 8 revisits the world of the subprime borrower to see how the problem of financing the less creditworthy can be solved without blowing up the world economy. Finally, Chapter 9 describes how the old-fashioned virtue of qualitative analysis is being combined with number crunching to mitigate the risk of a new pandemic.

Finance should have been scrutinized more intensively before the crisis. By the same token, it should be looked at with a clear eye now. Bright young people should be going into all sorts of different careers, and finance should be one of them. For all of its flaws, there is no more powerful problem-solving machine.

PART I: LESSONS BADLY LEARNED

1. Handmaid to History

Financial Sector Thinks It's About Ready to Ruin World Again

—The Onion

The history of financial innovation is also the story of human advance. The early forms of finance met some very basic needs—trade, safekeeping, credit. As societies and technologies have become more complex, so has finance. When maritime trade became more sophisticated, the banking and insurance industries put down roots. When industrialization created demand for more capital, the era of stock exchanges dawned. When financial instruments became more widely available and finance was democratized, governments responded by creating a more intrusive regulatory framework. When computerization took hold, the age of derivatives—financial products that derive their value from another, underlying, asset—soon followed. For good and bad, the industry that we know today is the product of centuries. And the world that we know today is a product of finance.

Money was the original financial breakthrough. Trade depends on the acceptance of a medium of exchange. Without an agreed form of money—whether notes, precious metals, or cowrie shells—every transaction would involve an arduous negotiation between buyer and seller over what form and quantity of payment would be appropriate. Without money, one of whose properties is that it retains some value over time, anyone who had only perishable goods to barter would find life very tough. You are prepared to accept money as payment because you know you can spend it in the future; you are less happy to accept payment in kiwifruits, say, because they will be exchangeable only for so long as they can be eaten.

Forms of money emerged to grease the wheels of trade as long ago as 9000 BC, when livestock were used as payment. Over time, precious metals emerged as a better form of money: they are less tasty than cows but more portable, durable, and divisible. The first coins were produced in Lydia, in what is now Turkey, in the seventh century BC. The coins were made of electrum, a naturally occurring mixture of gold and silver, and the technology soon spread to Greek cities. The first paper money was invented in China in the ninth century, paving the way for the modern system of fiat money, which is issued by the state and—unlike coins made of precious metals—has no intrinsic value.1

Even in modern times, fiat money can still be driven out by commodity forms of exchange. In the immediate aftermath of World War II in Germany, no one had any faith in the Reichsmark, the local currency. Instead, American cigarettes came to be used as the means of payment on the black market: cigarettes were divisible, they lasted well, there was a decent supply of them via imports by American troops, and demand was high—not least because they suppressed appetite in a time of rationing. Money can change its shape to suit the circumstances.2

Once ancient societies had an agreed form of exchange that could hold its value, they could develop more ambitious financial instruments. The earliest financial contracts date back to Mesopotamia in the fourth millennium BC: clay tablets inscribed with records of a person's obligation to pay would be sealed inside a type of clay envelope called bullae; these envelopes could themselves act as money, since the obligations they contained were payable to the bearer. Forms of payment ranged from honey to bread, but livestock seems to have been the type of "money" that gave the world the concept of interest. Herds of cattle or flocks of sheep have a natural tendency to multiply: you might lend someone twenty cows, and by the time you get them back, their number will have increased. Those extra heads would have acted as compensation for the risk of lending out the original herd. The evolving language of finance was drawn directly from this pastoral form of interest. The Sumerian word for interest was the same as the word for calves