The Economist: The Democratization of Finance

Article excerpt

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. …