Finance for Good

In his very interesting book “The new Financial Order” Robert J. Schiller talks about the importance of further developing finance to democratize it. He argues that the insights of finance have only been applied in a limited way. Democratizing finance, he argues, means effectively solving the problems of gratuitous economic inequality. He also claims that finance has to go beyond the domain of physical capital to human capital to cover the risks that really matters in our lives.

I totally agree with him. I think that there is so much more than finance can do and I do not think that it is a matter of whether this will happen or not but rather of when this will happen.

Professor Schiller provides some very interesting ideas about livelihood insurance, income linked loans, inequality insurance and other very interesting ideas. I would like to make the case here that people should analyze and manage the risks in their lives and hedge some of them using financial tools.

Let’s take for example the case of cancer. Cancer is an awful and growing disease. In the US, the probability of developing cancer is 1 in 2 for men and 1 in 3 for women. However not so many people hedge against this risk! How can one do that?

First, there are behavioral aspects of it that people can pay attention to. It has been proven that a balanced diet (low in fats!) and doing sport can help us limit this risk. Second, we could try to look for solutions to the problem. Obviously, we are not wise scientists capable of understanding or even expressing any meaningful thought about such a complex disease. However, we could do more to provide resources to the researchers that dedicate their life and talent to look for cures.

We are already doing this, to some extent. Annual R&D budget by the top 500 pharma and biotech companies reaches around $125b. This is quite a bit of money but if we divide it by the population of the countries where these companies were mostly born (US+EU+Japan= around 1300m people) the yearly investment in finding new drugs is around 95 USD/person. In addition to this, governments and foundations put sizeable amounts of money to work on research but it is no more than a fraction of the amount cited above and obviously not all of this money goes to find cures for cancer.

If a citizen wanted to invest in finding a cure to cancer he could invest his money in the equity or bonds of a pharmaceutical or biotech company or on a biotech index or he could give it to a foundation. This would be a good proxy for hedging himself but it would not be a great one in the sense that not all of these companies make similar efforts to find cures for every type of cancer. If in the family of this investor there were a specific gen related propensity to develop some type of cancer, he or she may not be able to put his savings to work to try to find a cure to that specific cancer.

Moreover, cancer is not the only risk for human health for which there is no cure. Let´s take Alzheimer, according to a recent report by the Alzheimer´s Association, one in six women aged 55 and older, and almost one in 10 men aged 55 and older will suffer Alzheimer. Unfortunately, we seem to be far from finding a cure to alzheimer and it is not easy to find alternative ways to invest money on its cure.

In our age of crowd financing and social media, it is hard to believe that we have not yet found a way to create channels to provide hedging solutions to individuals who would like to invest in cures to diseases. It is true that most of those investments would be very risky and so the fraction of savings invested should always bear in mind other circumstances of each individual but it is also important that we invest time, talent and effort in creating new channels, new securities, new tools though which, gradually, we offer economic agents solutions to live a better life, a safer life and to manage better their economic and human risks.

Some people argue that finance and finance professionals are only driven by greed, ambition and a total disregard of the social consequences of what financiers do. These feelings seem deeply rooted in society and they are stronger than ever nowadays, in the aftermath of the credit crisis of 2007-2010.

However I think that we cannot obviate the important role that finance has in our societies and its contribution to the progress of our World. Finance plays an major role as catalyst of economic growth. It facilitates the mobilization of resources that pay for our investments, infrastructures, research and even the universalisation of some of our rights such as is the case of those countries whose public debt grew to finance the expansion of healthcare or the pension systems.

Finance (and economics) work under the premise that resources are scarce (they have a price) and they have to be allocated efficiently. Economic agents and organizations, especially financial organizations live by that principle and try to optimize the allocation of their resources to maximize their value, i.e. their profits. One may expect that when economic agents act rationally and independently, their actions maximize their wealth and the joint wealth of their societies. UNFORTUNATELY, that is not always the case.

There are at least two examples of situations where individuals following their own interest act against the interest of the group:

-The first one is the case of “free riders”. Free riders are those who consume a resource without paying for it. Economic theory says this is a problem when it leads to the non production or under production of a public good. When economic agents do not pay their transportation tickets or their taxes but they consume the public goods (transport or public services) they may create a problem of under production of a good.

-The second one is often denominated the “tragedy of the commons”. It was first described in an article written by Garret Hardin and first published in the Science journal in 1968 (read more about it here). In Hardin´s article, each of the farmers who share a common land have individual interest in buying additional cows and in putting them to work since he/she receives all the benefits of the extra cow but the damage to the land (due to over grazing) is shared among all its users.

The recent crisis can be interpreted in light of these ideas. Bankers kept on giving mortgages and securitizing them because they were making short term profits and because competitors were doing in the same. A systemic risk, a risk for the entire economy was created and fueled. Nevertheless, bankers were not alone, basically almost every economic agent in this market could be blamed of having a share of responsibility, including the individuals who took mortgages they could not pay, the investors who bought securities they did not understand, the rating agencies who did not do a good rating work, the regulators who did not provide with a good regulatory framework to avoid risks for their economies, etc. All of these agents acted following what they thought were their rational interest but acting together they almost destroyed their “common”, their economy.

When a crisis like the recent one occurs, it impacts our economies in many ways. One of its consequences is that if public money is used to rescue private financial institutions. This can lead to a transfer of wealth from the tax payer to the equity holder of the financial institution. This can have an important regressive impact. The wealthy financiers and banking equity holders may enjoy the upside during the boom but face a limited downside during the crisis. This is just not right… It is probably early to confirm what the balance of the massive government intervention will be (we may never know it) but what is for sure is that income inequality keeps growing in the World.

The most common measure of income inequality is the Gini index. A score of 0 means perfect equality and 1 means that all the wealth of one country is in the hands of one person. According to an article recently published by the Economist (“The rise and rise of the cognitive elite”), the Gini index continues to grow in most countries. In the period between 1980 and the mid-2000s:

• US grew from 0.34 to 0.38
• Germany moved from 0.26 to 0.3
• China jumped from 0.28 to 0.4
• in only one large country, Brazil, the coefficient fell from 0.59 to 0.55

The knowledge and practice of finance has developed a lot over the last decades but in spite of the economic progress, we have not increase equality. This being said, some very exciting initiatives have been successful in providing more opportunities to the less favored or at least to a group of them.

Of particular importance has been the growth of microfinance. Microfinance began in the 1970s when social entrepreneurs began lending money on a large scale to the working poor. According to Investopedia, in 2007, the microfinance market served more than 33 million borrowers and 48 million savers. Statistics provided by Unitus, an organization devoted toward fighting global poverty show that 80% of the potential market has not yet been reached.

A very interesting company in this field is Kiva. Kiva is the world’s first person-to-person micro-lending website that uses internet and a network of microlending organizations to provide loans to the poor. Kiva is a great example of the power of crowd funding. According to wikipedia, crowd funding describes the collective cooperation, attention and trust by people who network and pool their money and other resources together, usually via the internet to support efforts initiated by other people or organizations. Crowd financing could be applied to anything and if will not be long before we see businesses taking advantage of this deregulated financial channel… and I guess that it will not be long either before we see some efforts to regulate it or scandals related to it, unfortunately.

Another interesting proposal to channel resources to the “third sector” (not for profit) was the creation of a Social Investment Bank, suggested by the Commission of Unclaimed assets (CUA). The CUA is an independent commission set up in November 2005 and chaired by Sir Ronald Cohen to propose recommendations for the use of monies in financial institutions in the UK that have been untouched by their owners for a considerable period of time. In its 2007 report, the Commission suggested  that an independent Social Investment Bank should be created  using the capital from dormant accounts to develop the social investment market  by acting as a wholesaler of capital. The SIB would:

-Capitalise financial intermediaries fromt he third sector

-Develop the provision of advice, support and risk investment to accelerate the growth of demand for repayable finance

-Develop programs of investment in markets such as community regeneration and financial inclusion

-Support existing third sector intermediaries in their efforts to raise private capital

Along these lines, Social Finance is a UK organization that designs and develops financial products that marry the needs of investors and the social sector (less favored groups of society), support organisations in their efforts to deploy and raise capital, and research social investment markets and opportunities. Social Finance is proposing the issuance of Social Impact Bonds. A Social Impact Bond (SIB) is a contract with the public sector in which a commitment is made to pay for improved social outcomes that result in public sector savings. SIBs are not traditional bonds but rather more like financial contracts where repayment to investors is contingent upon specified social outcomes being achieved.

There are many other examples of such great initiatives to use finance to help those more in need, to try to promote social equality and to use technology and finance for better. Although the practice of finance is not per se a mechanism to increase income equality or ensure social good, financial tools and principles can be used to give more opportunities to the less favored people in our societies, to provide public goods and to address social goals. Here again, it is up to us all to suffer the tragedy of the commons or to make the most of what we have, to dare to put new ideas in practice, fail sometimes and succeed many others.

The progress in life sciences financing has been quite extraordinary. The pressure of global competition, generics, lower capital efficiency and the capital drainage of the last 3 years has forced bio pharma companies to be more creative in how they try to finance their research and development of new drugs. Herein I summarize some thoughts and findings based on a number of public articles, consultant presentations, websites and sources of information about various alternatives of financing that have been tried:

Traditional equity investments:

• Traditional equity purchase: outright equity investments. Nowadays most investments are increasingly including contingent payments triggered by the satisfaction of various types of milestones and warrants to offer access to upside potential to investors.
• IPO (initial public offering): biotech market is cyclical. It was strong in 2004-07 (with around 30 deals per year and avg. $5.5b raised/year). Stock market weakness shifts focus to M&A.
• M&A (mergers and aquisitions): very active nowadays (around 40 in 2008, 3 times more than in previous years) in the form of partner buy-out deals and asset purchases (Buyer does not acquire the total equity of the company but only a negotiated part of its assets and liabilities attached)
• Other public deals, “bought deals”: a number of underwriters (bank or syndicate of financial institutions or investors) agree to buy an entire new equity issue. Often the acquisition of shares is accompanied by some warrants that allow investors to acquire more shares at pre agreed price over a period of time (usually goes up to 2 years). It has been used to finance drug development and even working capital needs.

Innovative partnerships: Some examples of partnering or alliance trends in oncology are:

• Equity purchase plus licensing rights related to the successful development of drugs (Novartis-Idenix deal is a good example). In other occasions investments are accompanied with options to increase equity holdings if some milestones are met (earnout clauses for former equity holders may also be included).
• Third party financing of pharma pipeline: like when the private equity firm TPG and Novaquest help Lilly develop its top 2 Alzheimer compounds. TPG paid clinical research services worth $275m and Novaquest (contract research organization[1]) paid $25m and offered advice on clinical trials. Lilly pays back $330m) based on milestones and single digit royalties of those 2 compounds if successful plus single digit royalties from another 3^rd compound.
• Capital project financing: Symphony capital finances early stage clinical development of a portfolio of company programs taking ownership of them as collateral. Upon completion of the proof of concept studio the innovator can buy back the program at a prenegotiated time dependant price or leave it to Symphony.

Intellectual Property related:

• Non recourse royalty financing: Insite Vision established a wholly owned subsidiary that issues a non recourse non convertible bond to be paid back using royalty cash stream from the sales of azithromycin solution, a branded pharmaceutical marketed by Inspire Pharmaceuticals, Inc
• Synthetic royalty: entitles Cowen Royalty (inventor of the concept that is got a copyright on it) to receive a stream of cash flow payments that are primarily secured by the future sales of the healthcare product (still being developed) as well as by the underlying product assets of the company that received the financing from Cowen. Cowen raised a $1b fund to do this.
• Structured royalty debt: securities that are collateralized by royalty streams (Already cash flow generating patents). The issuer usually places the royalty contract(s) into a special purpose vehicle and issues debt in the asset-backed securitization market.

In parallel to these new ways of financing drug research, big efforts are being put into helping improve the regulatory process and identifying new paths to test new compounds. It is a huge challenge and there are plenty of unknowns and risks. One relevant question is therefore: Can anything be done to improve the capital efficiency of biotech financing and successfully develop new drugs? I think the answer to this question is YES!

[1] Contract research organizations or CROs outsource clinical trial services

Financial innovation has been accused of being at least in part responsible for the financial crisis.

When it comes to finger pointing, I think that it is important to listen to experts who perfectly understand the topic we are talking about and then to apply a filter to care for the possible subjective biasses they may be subject to.

Last week Profesor Andrew Lo spoke about financial innovation on the Economics and Finance symposia organized to commemorate the 150th anniversary of MIT. On his participation he said that accusing securitization of being responsible for the crisis would be like accusing arithmetics of being responsible for accounting fraud.

The history of financial markets is plagued with innovations that have contributed to a more efficient channeling of resources from savers to investors. According to Professor Robert Merton what has driven innovation is three things: “need, need and need”. In fact, his theories about option valuation (that along with Black and Scholes granted him the Nobel prize) were quickly adopted among market practitioners in the 80´s due to the need to hedge against fx, interest rate and commodity prize volatility.

Let´s take a look now at one of the financial innovations that has been considered responsible, by some, 08-09 of the financial crisis: securitization.

Securitization had been actively used since the 80´s as a way to transfer risk and assets from the balance sheet of banks to the investor community. This facilitated an expansion in the credit available by banks who could sell their mortgage credits and consumer credit to investors and use the money they get in return to give more loans to consumers or constructors. This fueled more economic activity especially on the real state sector. This seems to be quite positive for an economy, does not it? Organizations like the IMF have stated that in fact, for the US economy to regain speed securitization has to be relaunched as it has become such an important part of the lending mechanism.

How important securitization is for the financial markets? The following graph about debt securities issuance in the US (source SIFMA)



According to the graph above, securitization gained weight since the advent of the new century and grew to represent around 50% of all debt issued in the US in 2005, 2006 and 2007. Still in 2009 it added up to around 30% of all debt issuance. It has thus become a major financial tool and one that plays a major role in the financing of the US economy.

So one could argue that securitization has played a important role by allowing banks to increase the lending offered to firms and consumers and by doing so fueling the dynamic growth of the 90´s and early 2000´s. This seems quite positive in itself.

However, the combination of this large supply of credit with economic policies that were to be too expansionary, inadequate regulation and bad market risk management practices, strong competition, greed and shortsightedness led the western economies into a near collapse of which some will take long time to recover.

Profesor Robert Jarrow participated in the conferences cited above and talked about bad risk management practices. He said that the use of the wrong models by financial institutions (the so called structured models) meant that they underestimated their risk exposure and that they were undercapitalized. He defended that there are other models (reduced form ones) that have worked reasonably well in measuring risk and in allowing its users to remain profitable before, during and after the crisis.

Modern finance has become increasingly complex and financial markets are very integrated. This means that understanding well the new products, its risks and its interconnected performance is vital and that market participants should ensure that appropriate resources are tasked to the role of pricing, understanding and carefully managing more complex balance sheets.

Given all what is said above, I would argue that securitization is a good financial innovation. As a tool it has been efficient in achieving its objectives. What markets and regulators have to figure out is how to use it without abusing it and how to define the right market and risk management practices to avoid putting in danger our economies and financial systems.

Financial innovation has helped our world progress and should continue to do so. Tools, products and risks have to be well understood, regulators and policy makers need to have the resources necessary to understand them well and the financial industry practitioners have to behave in more reasonable and responsible ways so we can altogether avoid future crisis like the 08-09 one. It is a big challenge and history proves odds are against us but I want to think positively about our chances to learn, to be better and do better in the future than we have done in the past.

Hi there,

After over a decade of work in finance I decided to leave capital markets for a while and to look for inspiration at MIT. I firmly believe that MIT is the most advanced window to the future of our World and that here I would find ideas, inspiration, challenges and the people to help me live my dreams.

I found inspiration in the lectures of Professor Andrew Lo, a visionary of finance, who believes that there is enough financial technology to address some of the challenges of humanity. The second time I heard him say that i could not resist to ask him what he exactly meant… and some weeks afterwards I found myself working for him in this amazing research adventure.

We are combining principles of portfolio theory and structured finance to try to design a new family of financial vehicles to raise money for scientific research. Our first experiment focuses on cancer research and you can read more about it on the web page of the Laboratory for Financial Engineering following the link called ¨structure finance for scientific research¨

In this page I will post information about the project and other related topics

Wish us luck, let´s see if we can prove that finance can do more and can do better for human kind!

PS: I want to thank Rafael Maranon his help setting up this blog. He is a firm believer and proponent of social media but above all that he is a good man and a patient friend. Gracias Rafa!…