Raising capital. One of the fascinating things in life, particularly in America, is that we can spend large sums of money that don’t belong to us. Financial markets enable us to borrow money. Sometimes this means that Visa and MasterCard indulge our eagerness to consume today what we cannot afford until next year (if then); more often—and more significant to the economy—borrowing makes possible all kinds of investment. We borrow to pay college tuition. We borrow to buy homes. We borrow to build plants and equipment or to launch new businesses. We borrow to do things that make us better off even after we’ve paid the cost of borrowing.
Sometimes we raise capital without borrowing; we may sell shares of our business to the public. Thus, we trade an ownership stake (and therefore a claim on future profits) in exchange for cash. Or companies and governments may borrow directly from the public by issuing bonds. These transactions may be as simple as a new car loan or as complex as a multibillion-dollar bailout by the International Monetary Fund. The bottom line never changes: Individuals, firms, and governments need capital to do things today that they could not otherwise afford; the financial markets provide it to them—at a price.
Modern economies cannot survive without credit. Indeed, the international development community has begun to realize that making credit available to entrepreneurs in the developing world, even loans as small as $50 or $100, can be a powerful tool for fighting poverty. Opportunity International is one such “microcredit” lender. In 2000, the organization made nearly 325,000 low-collateral or non-collateral loans in twenty-four developing countries. The average loan size was a seemingly paltry $195. Esther Gelabuzi, a widow in Uganda with six children, represents a typical story. She is a professional midwife, and she used a tiny loan by Western standards to set up a clinic (still without electricity). She has since delivered some fourteen hundred babies, charging patients from $6 to $14 each. Opportunity International claims to have created some 430,000 jobs. As impressive, the repayment rate on the micro-loans is 96 percent.
Storing, protecting, and making profitable use of excess capital. The sultan of Brunei earned billions of dollars in oil revenues in the 1970s. Suppose he had stuffed that cash under his mattress and left it there. He would have had several problems. First, it is very difficult to sleep with billions of dollars stuffed under the mattress. Second, with billions of dollars stuffed under the mattress, the dirty linens would not be the only thing that disappeared every morning. Nimble fingers, not to mention sophisticated criminals, would find their way to the stash. Third, and most important, the most ruthless and efficient thief would be inflation. If the sultan of Brunei stuffed $1 billion under his mattress in 1970, it would be worth only $180 million today.
Thus, the sultan’s first concern would be protecting his wealth, both from theft and from inflation, each of which diminishes his purchasing power in its own way. His second concern would be putting his excess capital to some productive use. The world is full of prospective borrowers, all of whom are willing to pay for the privilege. When economists slap fancy equations on the chalkboard, the symbol for the interest rate is r, not i. Why? Because the interest rate is considered to be the rental rate—r—on capital. And that is the most intuitive way to think about what is going on. Individuals, companies, and institutions with surplus capital are renting it to others who can make more productive use of it. The Harvard University endowment is roughly $25 billion. This is the Ivy League equivalent of rainy-day money; stuffing it under the mattresses of students and faculty would be both impractical and a waste of a tremendous resource. Instead, Harvard employs nearly two hundred professionals to manage this hoard in a way that generates a healthy return for the university while providing capital to the rest of the world.1 Harvard buys stocks and bonds, invests in venture capital funds, and otherwise puts $25 billion in the hands of people and institutions around the globe who can do productive things with it. From 1995 to 2005, the endowment earned an average 16 percent annual return, which is a lot more productive for the university than leaving the cash lying around campus. (Harvard also managed to lose 30 percent of its endowment during the financial crisis, so we’ll come back to the Harvard endowment when we talk about “risk and reward.”)2
Financial markets do more than take capital from the rich and lend it to everyone else. They enable each of us to smooth consumption over our lifetimes, which is a fancy way of saying that we don’t have to spend income at the same time we earn it. Shakespeare may have admonished us to be neither borrowers nor lenders; the fact is that most of us will be both at some point. If we lived in an agrarian society, we would have to eat our crops reasonably soon after the harvest or find some way to store them. Financial markets are a more sophisticated way of managing the harvest. We can spend income now that we have not yet earned—as by borrowing for college or a home—or we can earn income now and spend it later, as by saving for retirement. The important point is that earning income has been divorced from spending it, allowing us much more flexibility in life.
Insuring against risk. Life is a risky proposition. We risk death just getting into the bathtub, not to mention commuting to work or bungee jumping with friends. Let us consider some of the ways you might face financial ruin: natural disaster, illness or disability, fraud or theft. One of our primary impulses as human beings is to minimize these risks. Financial markets help us to do that. The most obvious examples are health, life, and auto insurance. As we noted in Chapter 4, insurance companies charge more for your policy than they expect to pay out to you, on average. But “average” is a really important term here. You are not worried about average outcomes; you are worried about the worst things that could possibly happen to you. A bad draw—the tree that falls in an electrical storm and crushes your home—could be devastating. Thus, most of us are willing to pay a predictable amount—even one that is more than we expect to get back—in order to protect ourselves against the unpredictable.
Almost anything can be insured. Are you worried about pirates? You should be, if you ship goods through the South China Sea or the Malacca Strait. As The Economist explains, “Pirates still prey on ships and sailors. And far from being jolly sorts with wooden legs and eye patches, today’s pirates are nasty fellows with rocket-propelled grenades and speedboats.” There were 266 acts of piracy (or attempts) reported to the International Maritime Organization in 2005. This is why firms sending cargo through dangerous areas buy marine insurance (which also protects against other risks at sea). When the French oil tanker Limberg was rammed by a suicide bomber in a speedboat packed with explosives off the coast of Yemen in 2002, the insurance company ended up writing a check for $70 million—just like when someone backs into your car in the Safeway parking lot, only a much bigger claim.3
The clothing and shoe company Fila should have bought insurance before the 2009 U.S. Open tennis tournament, but didn’t. Like other such companies, Fila endorses athletes and pays them large bonuses when they do great things. Fila endorses Belgian tennis player Kim Clijsters, winner of the U.S. Open, but opted not to buy “win insurance” for the roughly $300,000 in bonus money they had promised her for a victory. (This was an expensive decision, but perhaps also an insulting one for Ms. Clijsters.) The insurance would have been cheap; Clijsters was unseeded, had played only two tournaments since leaving the game to have a baby, and was considered a 40–1 long shot by bookies before the tournament.4
The financial markets provide an array of other products that look complicated but basically function like an insurance policy. A futures contract, for example, locks in a sale price for a commodity—anything from electrical power to soybean meal—at some defined date in the future. On the floor of the Board of Trade, one trader can agree to sell another trader a thousand bushels of corn for $3.27 a bushel in March of 2010. What’s the point? The point is that producers and consumers of these commodities have much to fear from future price swings. Corn farmers can benefit from locking in a sale price while their corn is still in the ground—or e
ven before they plant it. Might the farmers get a better price by waiting to sell the crop until harvest? Absolutely. Or they might get a much lower price, leaving them without enough money to pay the bills. They, like the rest of us, are willing to pay a price for certainty.
Meanwhile, big purchasers of commodities can benefit from being on the other side of the trade. Airlines use futures contracts to lock in a predictable price for jet fuel. Fast-food restaurants can enter into futures contracts for ground beef, pork bellies (most of which are made into bacon), and even cheddar cheese. I don’t know any Starbucks executives personally, but I have a pretty good idea what keeps them awake at night: the world price of coffee beans. Americans will pay $3.50 for a grande skim decaf latte, but probably not $6.50, which is why I would be willing to bet the royalties from this book that Starbucks uses the financial markets to protect itself from sudden swings in the price of coffee.
Other products deal with other risks. Consider one of my personal favorites: catastrophe bonds.5 Wall Street dreamed up these gems to help insurance companies hedge their natural disaster risk. Remember, the insurance company writes a check when a tree falls on your house; if a lot of trees fall on a lot of houses, then the company, or even the entire industry, has a problem. Insurance companies can minimize that risk by issuing catastrophe bonds. These bonds pay a significantly higher rate of interest than other corporate bonds because there is a twist: If hurricanes or earthquakes do serious damage to a certain area during a specified period of time, then the investors forfeit some or all of their principal. The United Services Automobile Association did one of the first deals in the late 1990s tied to the hurricane season on the East Coast. If a single hurricane caused $1.5 billion in claims or more, then the catastrophe bond investors lost all of their principal. The insurance company, on the other hand, was able to offset its claims losses by avoiding repayment on its debt. If a hurricane did between $1 billion and $1.5 billion in damage, then investors lost a fraction of their principal. If hurricanes did relatively little damage that year, then the bondholders got their principal back plus nearly 12 percent in interest—a very nice return for a bond.
The same basic idea is now being used to protect against terrorism. The World Football Federation, which governs international soccer, insured the 2006 World Cup against disruption due to terrorism (and other risks) by issuing $260 million in “cancellation bonds.” If the tournament went off without a hitch (as it did), the investors get their capital back along with a handsome profit. If there had been a disruption serious enough to cancel the World Cup, the investors lose some or all of their money, which is used instead to compensate the World Football Federation for the lost revenue. The beauty of these products lies in the way they spread risk. The party selling the bonds avoids ruin by sharing the costs of a natural disaster or a terrorist attack with a broad group of investors, each of whom has a diversified portfolio and will therefore take a relatively small hit even if something truly awful happens.
Indeed, one role of the financial markets is to allow us to spread our eggs around generously. I must recount one of those inane experiences that can happen only in high school. Some expert in adolescent behavior at my high school decided that students would be less likely to become teen parents if they realized how much responsibility it required. The best way to replicate parenthood, the experts reckoned, would be to have each student carry an egg around school. The egg represented a baby and was to be treated as such—handled delicately, never left out of sight, and so on. But this was high school. Eggs were dropped, crushed, left in gym lockers, hurled against the wall by bullies, exposed to secondhand smoke in the bathrooms, etc. The experience taught me nothing about parenthood; it did convince me forever that carrying eggs is a risky proposition.
The financial markets make it cheap and easy to put our eggs into many different baskets. With a $1,000 investment in a mutual fund, you can invest in five hundred or more companies. If you were forced to buy individual stocks from a broker, you could never afford so much diversity with a mere $1,000. For $10,000, you can diversify across a wide range of assets: big stocks, small stocks, international stocks, long-term bonds, short-term bonds, junk bonds, real estate. Some of those assets will perform well at the same time others are doing poorly, protecting you from Wall Street’s equivalent of bullies hurling eggs against the wall. One attraction of catastrophe bonds for investors is that their payout is determined by the frequency of natural disasters, which is not correlated with the performance of stocks, bonds, real estate, or other traditional investments.
Even the much-maligned credit default swaps have a legitimate investment purpose. A credit default swap is really just an insurance policy on whether or not some third party will pay back its debts. Suppose your husband pressures you to loan $25,000 to your ne’er-do-well brother-in-law so that he can finally complete his court-man-dated anger management program and turn his life around. You have grave concerns about whether you will ever see any of this money again. What you need is a credit default swap. You can pay some other party (presumably with a more favorable view of your brother-in-law’s creditworthiness) to enter into a contract with you that promises to pay you $25,000 in the event that your brother-in-law does not pay back the cash. The contract functions as insurance against default. Like any other kind of insurance, you pay for this protection. If your brother-in-law gets his act together and pays back the loan, you will have purchased the credit default swap for nothing (which is how the other party to the transaction, or the counterparty, makes its money). How could something so simple and seemingly useful contribute to the near collapse of the global financial system? Read on.
Speculation. Of course, once any financial product is created, it fulfills another basic human need: the urge to speculate, or bet on short-term price movements. One can use the futures market to mitigate risk—or one can use the futures market to bet on the price of soybeans next year. One can use the bond market to raise capital—or one can use it to bet on whether or not Ben Bernanke will cut interest rates next month. One can use the stock market to invest in companies and share their future profits—or one can buy a stock at 10:00 a.m. in hopes of making a few bucks by noon. Financial products are to speculation what sporting events are to gambling. They facilitate it, even if that is not their primary purpose.
This is what went wrong with credit default swaps. The curious thing about these contracts is that anyone can get into the action, regardless of whether or not they are a party to the debt that is being guaranteed. Let’s stick with the example of your loser brother-in-law. It makes sense for you to use a credit default swap to protect yourself against loss. However, that same market also allows the rest of us to bet on whether or not your brother-in-law will pay back the loan. That’s not hedging a bet; that’s speculation. So for any single debt, there may be hundreds or thousands of contracts tied to whether or not it gets repaid. Think about what that means if your brother-in-law starts skipping his anger management classes and defaults. At that point, a $25,000 loss gets magnified thousands of times over.
If the parties guaranteeing that debt haven’t done their homework (so they don’t truly understand what a loser your brother-in-law is), or if they don’t care (because they earn big bonuses for making dubious bets with the firm’s capital), then an otherwise small set of economic setbacks can explode into something bigger. That’s what happened when the American economy hit a real-estate-related speed bump in 2007. AIG was the firm at the heart of the credit default debacle because it guaranteed a lot of debt that went bad. In his excellent 2009 assessment of the financial crisis, former chief economist for the International Monetary Fund Simon Johnson writes:
Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 million in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood sec
urities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed to about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.6
Raising capital. Protecting capital. Hedging risk. Speculating. That’s it. All the frantic activity on Wall Street or LaSalle Street (home of the futures exchanges in Chicago) fits into one or more of those buckets. The world of high finance is often described as a rich man’s version of Las Vegas—risk, glamour, interesting personalities, and lots of money changing hands. Yet the analogy is terribly inappropriate. Everything that happens in Las Vegas is a zero-sum game. If the house wins a hand of blackjack, you lose. And the odds are stacked heavily in favor of the house. If you play blackjack long enough—at least without counting cards—it is a mathematical certainty that you will go broke. Las Vegas provides entertainment, but it does not serve any broader social purpose. Wall Street does. Most of what happens is a positive-sum game. Things get built; companies are launched; individuals and companies manage risk that might otherwise be devastating.
Naked Economics Page 19