In a passage from his new book, The Lexus and the Olive Tree, the Pulitzer Prize-winning journalist tracks global ization's biggest revolution: how control of capital has been transferred from the few to the hands of the many. First of two parts. BY THOMAS L . FRIEDMAAN
The democratization of technology helped foster an enormous change driving globalization, and that is the change in how we invest. I call this "the democratization of finance." For much of the post-Cold War era, most large-scale domestic international lending or underwriting was done by the big commercial banks, investment banks, and insurance companies. These white-shoe institutions always preferred lending to companies with proven track records and "investment-grade" ratings. This made bank-lending not very democratic. The old-line banks had a limited notion of who was creditworthy, and if you were an upstart, trying to get access to cash often depended on whether you had an "in" at the bank or insurance company. These traditional institutions also tended to be run by slow-moving exectives and decisionmaking committees that were risk-averse and not particularly swift at responding to changes in the marketplace.
The democratization of finance actually began in the late 1960s with the emergence of the "commercial paper" market. These were bonds that corporations issued directly to the public in order to raise capital.The creation of this corporate bond market introduced some pluralism into the world of finance and took away the monopoly of the banks. This was followed in the 1970s by the "securitization" of home mortgages. Investment banks started approaching banks and home mortgage companies, buying up their whole portfolio of mortgages, and then chopping them up into $1,000 bonds that you and I and my Aunt Bev could buy.We got a chance to earn a little more interest on a pretty secure investment, and the interest and principal on bonds was paid out from the monthly cash flow from people paying off their home mort- gages. Securitization opened the doors for all kinds of companies and investors who never had access to cash before to raise money.
It was in the 1980s, though, that this democratization of finance really exploded, and the man who truly pushed out the last barri ers was the brilliant, mercurial but ultimately corrupt junk bond king, Michael Milken. Milken, a graduate of the Wharton School of Business and Finance at the University of Pennsylvania, got his start with the Drexel brokerage firm in Philadelphia in 1970. At the time, none of the big banks or investment houses cared to have much to do with selling low-rated "junk bonds," which in those days were primarily blue-chip companies that had fallen from grace or start-ups with little capital and no track record. Milken thought the major banks were stupid. He did his own calculations, studied some of the little noticed academic research on the subject of junk bonds, and concluded the following: Companies that were not considered investment grade were being asked to pay interest rates three to 10 percentage points higher than the norm-if they could get any loans at all. But in fact these companies went bankrupt only slightly more often than the top-- rated blue-chip companies, whose bonds offered much lower rates of return. Therefore, these so-called junk bonds actually offered a chance to make a lot more money without a lot more risk. And if you put a lot of different junk bonds together into a single fund, even if a few of them defaulted, the total fund would still pay an average return three or four percentage points higher than the blue chips, with virtually no extra risk.
Since traditional banks and investment houses were skeptical, and continued to shun this business, Milken quickly moved from trading those junk bonds that already existed, from fallen grade-A companies, to underwriting a whole new market full of only junk players-risky companies, fallen companies, new companies, entrepreneurs and start-ups who could not get credit from the traditional banks, even financial pirates who wanted to take over other companies but couldn't raise the cash to do it through conventional bank channels. Because of his contacts, Milken could also sell the junk bonds he issued to mutual funds, private investors, and pension funds, which realized that he was right about their providing higher returns for not much higher risks. This gave you, me, and my aunt Bev a chance to buy a slice of these deals that had previously been off-limits to the little guy.
A similar democratization of finance was happening internationally. For decades, big banks lent large amounts of money to foreign governments, states and corporations and then carried these loans on their books at par value. That meant that if your bank lent a country or company $10 million, it showed up on their books as a $10 million loan to be repaid in full, whether or not this country or company had assets worth $10 million on that particular day. Because these loans were made primarily by banks and carried on their books, when a country like Mexico got into financial trouble, as it did in 1982, by borrowing abroad to finance populist consumption at home, banks bore the brunt of the problem. Mexico's president could fly to New York City, call together the 20 leading banks holding Mexico's foreign debt, and say to them essentially: "Gentlemen, we're broke. And you know what they say: If a man owes you $1,000,that's his problem. If a man owes you $10 million, that's your problem. Well, we're your problem.We can't pay our debts. So you are going to have to cut us some slack, renegotiate our loans and extend us fresh credit The bankers would nod their heads and work out some deal, involving loan extensions (usually at even higher interest rates). What choice did they have? Mexico was their problem, and the US bankers did not want to have to go back to their shareholders and say this Mexican loan that they were carrying on their books as a $10 million asset was actually worth nothing. Better to just carry the Mexicans along. And because 20 banks managed most of the debt, they could settle the whole thing in a single boardroom.
But then a funny thing happened on the way to globalization.This international debt market got securitized, just like Milken's companies and friends. What this meant was that when Latin America got into another debt crisis in the late 1980s, then Treasury Secretary Nicholas Brady tried a Milkenesque solution. In 1989 the Latin American debts of the major commercial banks were converted into US government-backed bonds, and those bonds were then either held by the banks as assets or sold to the general public, to mutual funds, and to pension funds, with higher than normal rates of interest. Suddenly you and I and my Aunt Bev could buy a piece of Mexico's debt, Brazil's debt or Argentina's debt-either directly or through our pension and mutual funds. And those bonds traded every day, with their value going up and down according to each country's economic performance.They just did not sit on a bank's books at par value.
Said Joel Korn, who headed Bank of America Brazil at the time: "What Brady did was really a revolution. Before hirn, the US Treasury Department was simply pressing the US banks and the IMF to keep throwing good money after bad at these Latin American countries. What Brady did was put together a market-based solution. Banks were given US government guarantees to extend new loans to Latin America, on condition that the countries made economic reforms. After extending these loans, the banks, instead of just carrying them on their books, chopped these loans up into US government-backed bonds that were sold to the public. That brought thousands of new players into the game. Instead of a country dealing with a committee of 20 major commercial banks, it suddenly found itself dealing with thousands of individual investors and mutual funds.This expanded the market, and it made it more liquid, but it also put a whole new kind of pressure on the countries. People were buying and selling their bonds every day, depending on how well they performed. This meant they were being graded on their performance every day.And a lot of the people doing the buying and grading were foreigners over whom Brazil, Mexico, or Argentina had no control?These bond holders were not like the banks, which, because they were already so exposed to these countries, felt they had to keep lending more money to protect their earlier loans. If a country didn't perform, the public bondholders would just sell that country's bonds, say good-bye and put their money into bonds of a country that did perform.
Name: Thomas L. Friedman
Background: Pulitzer Prize-winning journalist for the New York Times.
Most recent accomplishment: The Lexus and the Olive Tree, published by Farrar, Straus & Giroux
Name: Thomas L. Friedman
Background: Pulitzer Prize-winning journalist for The New York Times.
Most recent accomplishment: The Lexus and the Olive Tree, published by Farrar, Straus & Giroux…