In 1986, Merton Miller, a Chicago economist and an eventual Nobel laureate in economic sciences, asked if any 20-year period in history had resulted in a tenth as much financial innovation as the previous two-decade span. His own answer was a resounding ‘no’. He then went on to argue that innovation was flagging.
Four titans from that period addressed Miller’s question at the Milken Institute’s annual conference in Los Angeles, held last spring, in which the Wharton School was a participant. The panel on financial innovation included Michael Milken, Lewis Ranieri, Richard Sandor and Myron Scholes. It was moderated by Glenn Yago, director of capital studies at the Milken Institute, a West Coast business and public-policy research institute.
So what was their take? Yes, Miller was right about the period from the mid-1960s through the mid-1980s, when these four rainmakers earned their spurs. But then, they said almost in unison, financial innovation got sluggish, stuck in a kind of post-coital lethargy. However, it’s again poised to scale the ramparts, beating back skeptics, naysayers and foot-draggers who think nothing much new is in the offing.
For those who are unsure, here’s a quick recap of the Fab Four. Michael Milken, touted as the “junk bond king,” used his perch at Drexel Burnham Lambert to single-handedly open up the capital markets in the 1980s to risky companies cold-shouldered by investment banks. (In 1987 he famously earned a staggering $550 million; two years later he was charged with insider trading and price manipulation, and a year later copped to lesser securities violations, ultimately spending 22 months in jail.)
Lewis Ranieri helped create the multi-trillion-dollar mortgage-backed securities market which radically altered the landscape of American investment. Richard Sandor created futures on U.S. Treasury bonds and other interest rate products in the mid-1970s and is now devising markets for environmental commodities. And Myron Scholes co-invented the ever-present Black-Scholes options pricing formula with the late Fischer Black and Robert Merton, snagging a Nobel Prize in 1997 for his effort.
Pipe Dreams and Structural Change
Yago kicked things off by asking Ranieri what big problem he saw in the U.S. mortgage market in the early 1970s. The answer: the limited availability of funds. Baby boomers coming of age needed funding and housing. It was unlikely the thrifts could grow their balance sheets to meet the demand, he said. At the same time, the cost of capital made affordability a pipe dream for many. The challenge was to put together a system to free up enough dollars so that almost anyone who wanted a mortgage could get one.
That involved creating a secondary market for securitizations of residential mortgages so banks could manage their loan portfolios and diversify risks efficiently. Creating this market also required changing the laws so institutional investors could invest in this new asset class and absorb the risk being shed by others.
Sandor took a loftier, bird’s-eye view of the process of innovation. He noted that structural change is often the necessary catalyst for the development of a market. “Markets tend to happen and evolve over time in very standard ways,” he said. In the late 1960s and early 1970s, the structural change that occurred involved interest rates. Earlier, the assumption was that interest rates don’t fluctuate. But at Stanford University in the 1960s, he said, you could look out the door and see the changes taking place. The reigning belief that interest rates wouldn’t become volatile gradually began to shift.
Once the initial structural change occurs, making a new market possible, continued Sandor, uniform standards for the “commodity” in question must develop and legal instruments must be formed. Then come exchanges and forward markets, futures and options exchanges, and finally over-the-counter markets, which offer what he called “deconstructed products.”
From Credit to Quantification
Milken approached the question of innovation by asking what makes a community prosper. The same thing, he noted, that creates jobs, financial independence, economic growth, entrepreneurship and so on. In a word: credit.
In the 1980s, he said, “I saw a lack of understanding of credit. A country was considered the best credit … and small businesses were [considered] the worst credit.” This mistaken view shut companies that weren’t established out of the capital markets, making it impossible for them to raise funds efficiently or expand their businesses.
The first half of the puzzle, said Milken, was to create a high-yield bond market, investors, and the statistical data to show investors that they could get a good long-term rate of return. The second half was understanding the capital structure of a company. It’s one thing to issue securities; it’s another to realize that securities “exist on a continuum from senior debt to options,” and that a company must manage its balance sheet “as its fortunes change.” What’s important, he went on, is understanding that debt “has many characteristics and that debt becomes [similar to] equity as credit deteriorates and more like countries as it improves.”
The mid-1980s, he added, was the window when the United States was most open to new financial instruments. That’s when Sun Microsystems, Oracle and Microsoft went public; not incidentally, in his view, job growth accelerated in step with the changes taking place.
Scholes also took a turn around the Millerian block. Financial innovation occurs when lower-cost solutions are developed to address clients’ problems, he noted. The resulting services or products enable markets to become more efficient. In particular, increases in computing power in the 1960s and 1970s and greater sophistication in measurement greased the rails of innovation. When he started in finance in the late 1960s, the importance of measurement was an open question. Back then, there was “no ability to measure the performance of pension funds,” he said.
Talking about the hive of modeling activity that took place after he and Fischer Black built their options-pricing model, which fueled the growth of the derivatives market, he pithily explained: “Once we had a theory, great innovation occurred from the theory.” Advances to the model by other people extended the frontier of financial engineering. Having an options pricing technology was the building block that enabled investment banks and brokerages to design products.
Sandor added that innovation frequently occurs in spades with products meant for the wholesale markets, because they tend not to be patented. On Wall Street, the day you put out a new product, there’s a Xerox machine lying in wait, he said. The only way for firms to “monetize the rewards” of financial innovation is to keep on inventing.
The Devil’s Bargain
Yago took his cue, steering the conversation to the barriers of innovation. Once a social problem is identified, he asked, what are the challenges and barriers to developing a private-sector approach to addressing the problem?
In the mortgage market, said Ranieri, the obstacle was regulatory. “The innovation was that we had to find a way to make the assets finance themselves shorn of a balance sheet,” he explained. In effect, he and others had to invent securitization in the mortgage arena. It took 15 years of writing laws and getting federal exemptions and in the process they made a series of “devil’s bargains,” he said. This is important, he added, since people now tend to forget about those compromises.
All legislation requires the creation of rules and institutions. In 1984 Congress passed the Secondary Mortgage Market Enhancement Act, a set of doing-business issues, as Ranieri put it. But the bigger issue that had to be solved involved the tax code. The idea was to get Congress to give asset-backed securities their own section of the tax code. That plan didn’t work, said Ranieri, because the Treasury Department and the Office of the Comptroller of the Currency “were willing to accommodate us for housing but unwilling to accommodate us beyond that.” Eventually the bill was redrawn, but applied only to housing. The Tax Reform Act of 1986 was duly passed, permitting Real Estate Mortgage Investment Conduits, or REMICs, with multiple structures to be tax-exempt and allowing Real Estate Investment Trusts to invest in mortgage-backed securities. The devil’s bargain, in Ranieri’s view, is that the law applied to housing but left commercial real estate and credit cards receivables, for example, out in the cold, with no recourse to the efficiencies of the capital markets.
The development of interest rate futures also faced a regulatory battle and an enabling-legislation battle. “In the 1970s, the only regulator that could have handled financial futures, bonds and so on was the SEC,” said Sandor. “But the model they had didn’t really work because they had enormous transactions costs – prospectuses and things that wouldn’t apply to futures.”
Two things occurred. Those favoring trading in financial futures got Congress to update the list of tradable commodities, adding the word “intangible” to the description of regulated commodities. This permitted the trading of futures on equity indices, Treasury bonds and other underlying instruments that did not fall into the category of “tangible” commodities such as wheat, onions, soybeans and pork bellies.
The other change was that in 1974 Congress overhauled the Commodity Exchange Act of 1922, creating the Commodity Futures Trading Commission, and then granted the CFTC exclusive jurisdiction over futures. (Futures on single stocks and narrow-based equity indexes sat on the sidelines for 20 years while the CFTC and Securities and Exchange Commission duked out jurisdictional issues, until last year when the regulators allowed the products to begin trading.)
In the corporate debt market, regulation was the obstacle to change, noted Milken. A series of regulations made it impossible for institutional investors to buy bonds from other institutions or to swap one bond for another, and it took a long time for a pension fund or insurance company to be able to “sell a bond prior to maturity and buy another bond.”
This highlighted a double-decker problem, said Milken. First was the widespread inability to understand numbers and measure things, as Scholes had observed. “Everybody looked at investments based on the past, not the future,” said Milken. “Everybody looked at credit based on the past, not the future.” They looked at reported earnings, not cash flow, and credit analysis didn’t exist, even in the most sophisticated companies. Moreover, there was little desire for transparency. Companies didn’t want to be rated because they didn’t want to hear that they were a single-B or double-B. “In the public market, when you started getting rated, and judged, you started having to measure performance,” he said.
The second problem was the lack of education. There was little general understanding about what access to capital meant, and there was great resistance to change. Even now resistance continues. “We’re still seeing statements made that it isn’t okay for a farmer to hedge against prices in his wheat,” said Milken. “We are protecting ourselves from the things that protect us and allow us to survive.” In his view, the backlash against derivatives and other complex products is misplaced. “This is a constant vigil,” he added. “Not just in Mexico but in the United States today.”
Ranieri agreed. In South America, as in other parts of the developing world, he said, grudging progress is being made in the area of risk management and derivatives. “It is politically difficult to get them to see the benefit,” he said. “They see only the disequalizing of the embedded power bases rather than the long-term benefit.” He pointed to another basic issue in developing countries: property rights. “You can’t securitize something when you can’t put a lien on it,” he noted.
The Future of Air and Water
Looking forward, the panelists agreed that there is enormous potential for unprecedented innovation – and innovation that could potentially transfer large sums of wealth to developing countries. Milken noted that the biggest commodities haven’t yet been tapped: air and water. And in their case, it’s possible to have one’s cake and eat it too, by owning the asset and getting a tradable environmental benefit from it.
Sandor, the reigning deity on markets for environmental commodities, is chairman of the newly formed Chicago Climate Exchange, which plans to begin trading greenhouse gas emissions in North America in a voluntary private program this fall. As he explained it, once carbon dioxide emissions rights and biodiversity credits become established, a country like Costa Rica could extract value from eco-tourism because of its tropical rain forests, as well as from the “hidden” carbon sequestration credits that counter global warming. But he also agreed that for these programs to work globally, property rights are critical.
Although the real value of these assets is not known, Sandor pointed out that the Economist had estimated that annual trading in carbon rights could reach $60 billion to $1 trillion per year by 2012. Water, he speculated, may be as valuable a commodity as energy in a century. Moreover, the spillover benefits in terms of peace, natural resources and conflict resolution in the Middle East and elsewhere are immense.
Ranieri added that a curious twist in the tail is that the financial industry is having more success in new-product areas like the environment in developing countries rather than developed countries. He pointed to the cap-and-trade program in greenhouse gas emissions in Mexico. The reason is that while property rights are less developed, the idea of public goods faces fewer obstacles. The financial industry, he said, “may make market forces work in a very unusual way by starting someplace you would normally not go to first.”
Scholes took up the cudgels, noting that “we’ve seen nothing yet in our own country,” and that financial innovation remains in an “embryonic” stage. From where he sits, new areas for financial innovation include low-income transaction processing, such as sending money overseas and refinancing loans; the funding of large-scale projects, and saving money for the future.
More inventive risk-sharing and risk reduction for companies as well as individuals will also come about in the future, he predicted. Another function of finance is understanding pricing and valuation signals that help people make decisions and reallocate assets in the economy. More work can be done in this area to make markets more transparent. And finally, academics and modelers can work to reduce market frictions like asymmetric information.
For Sandor, seeding the future to allow and encourage all manner of innovation depends on education. Education is the “single biggest building block we need to further ideas,” he charged, and the key is getting academics involved and getting these new ideas into the curriculum, both here and in developing countries. There’s no guarantee, but Merton Miller would probably agree with that.