Tuesday, June 14, 2011

An early form of Securitization

Securitization is not new. This excerpt from Fault Lines: How Hidden Fractures Still Threaten the World Economy details one of the earlier examples:

When the French Monarchy was strapped for money in the eighteenth century, it found more and more creative ways to raise funds. One of these was to sell annuities—government bonds that paid out a fixed amount until the death of the person on whom the annuity was written. Annuities were very popular with the public, for they offered beneficiaries a guaranteed income for life in a time before they were old-age pensions. The monarchy liked them because it received the payment up front.

The monarch targeted these annuities at wealthy men—typically in their early fifties—who had the means to buy an annuity and who, given low life expectancies at that time, typically did not have very long to live. Annuities were priced so that they were a fair deal for such mean. However it was possible for the buyer of the annuity to make the payments dependent not on his own life span, but on that of someone else. Perhaps this loophole was not inadvertent, for it increased demand for the annuities: for example, it might have made annuities attractive to a wealthy merchant who wanted to settle his daughters for life. But it did mean that the clever investor could make money off the government. He could pick as beneficiaries healthy young girls (then as now, women lived longer than men) whose family history suggested a genetic predisposition to long life, and who had survived early childhood (infant mortality was very high in those times) as well as the dreaded smallpox. He could then buy annuities on their lives from the French government. A carefully selected, healthy ten-year-old girl would have much higher odds of surviving for a long time than the typical beneficiary of the annuity, and the payments received during her lifetime would far exceed the cost of the annuity.

This is indeed what a group of Geneva bankers did. They selected groups of thirty suitable girls in Geneva and purchased a life annuity on each from the French government. They then pooled the annuities so as to diversify the risk of accidental early mortality among the girls and sold claims on the resulting cash inflows to fellow citizens of Geneva. This early form of securitization thus allowed the bankers to create a virtual money machine, buying policies cheaply from the French government and reselling them for a higher price to investors. The investments were popular—especially because the bankers were reputable and the underlying annuities were claims on the government—and sold well.

However, buyers had not reckoned with the risk of government default. When the French revolution broke out in 1789, the monarchy was overthrown, and the revolutionary government soon fell behind in its annuity payments. It eventually made the payments in worthless currency. The Geneva bankers, who owed investors in harder Swiss currency, did not have the wherewithal to pay, and they defaulted, as in turn did many of the investors who had borrowed to invest in the "sure" thing.

Buy Fault Lines