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Fast Forward For Finance

Special Report -- The 21st Century Economy -- How It Will Work


Revolutions in finance, management, manufacturing, and selling are changing the rules of engagement

Financial engineers don't wear white lab coats. They don't experiment on rats or perform gas chromatography. Their raw material--money--isn't as jazzy as what biologists and physicists investigate. But the innovations they produce will contribute just as much to economic growth.

Maybe more, in fact. Because without the science of finance, all other sciences are just a bunch of neat concepts. Ideas begin to contribute to human betterment when they're financed--by venture capital, stock offerings, loans, or buyouts. A smoothly operating financial system showers money on good ideas. Equally important, it cuts off funding to tired ideas and tired companies, so their assets can be deployed more efficiently elsewhere. (The lack of such a process in Japan helps explain why that nation remains part of the old economy.)

The finance revolution in the past 25 years rivals the one that gave us the microchip. Look at the changes: Mortgage loans are cheaper because financiers have found a way to repackage them so they can be resold. Profits are more predictable because companies hedge risks. Employee stock options align workers' interests with shareholders'. Initial public offerings are fast and easy. And people have more investment choices than there are flavors of ice cream.

This is only the start. The new finance will master money in the same way computers master data and biotechnology has begun to master DNA. With their new theoretical tools, financial engineers can break down any raw investment into its components, then synthesize from them something more salable: not just mortgage-backed securities but also strips, swaps, swaptions--the list goes on.COMMODITIZED. The entire economy benefits when financial rocket scientists create products that simultaneously meet the needs of those who supply capital and those who use it. Sums up finance pioneer Myron S. Scholes, co-winner of the 1997 Nobel prize in economics: "When you make the markets more efficient, the cost of capital falls. The cost of capital falling results in enhanced output, and consumers as a whole are better off."

In The 21st Century Economy, innovation in finance will increase in concert with the increase in competition. Partly because of deregulation and globalization, competition should get tougher, and margins thinner. As products such as home mortgage loans become commoditized, financial-service companies will be forced to get more creative. Soon, says Henry Birdseye Weil, a senior lecturer at Massachusetts Institute of Technology's Sloan School of Management, "financial services will be almost indistinguishable from any other software business, with continual innovation and preemptive cannibalization."

Financial technology will keep feeding off information technology. Weil says the secret to success will be a strong software platform, which will lower the cost of generic services while making it possible to create high-margin variations as well. Says Weil: "A few companies that get it right can spin away from the rest and become stronger and stronger."

In the new world of finance, size counts. Big companies enjoy economies of scale and name recognition, and they can be safer because their bets are spread across more regions and market segments. The value of U.S. bank mergers in the first half of 1998 was greater than that of the three previous years combined. The mergers are occurring across industries as well. The proposed $70 billion combination of Travelers Group Inc. and Citicorp into Citigroup would bring under one roof commercial, personal, and investment banking, as well as stockbroking and insurance.

Pressures to consolidate will intensify as the big get bigger. In eight years, financial services will be dominated by 5 to 10 global companies, each with a full array of services, predicts Steven M. Gluckstern of Capital Z Partners, a newly formed New York firm that will invest in financial companies. In addition, predicts Gluckstern, there will be five or six big companies that will be primarily advisers and brokers, such as Chicago's Aon Corp., one of the world's biggest insurance brokers.

At the other extreme will be specialists that survive by doing one thing either very cheaply or exceptionally well. Gluckstern, who is also nonexecutive chairman of Zurich Reinsurance Inc., predicts that companies caught in between the extremes will wither: "It will start to look like a barbell."

By offering lower prices or better service, specialists will discipline the financial supermarkets; the big guys know their customers can walk away if they get a raw deal. "There is no way we are going to maximize a short-term transactional benefit at the risk of destroying a long-term relationship," says Chase Manhattan Corp. Vice-Chairman Joseph G. Sponholz.

Predictably, the biggest winners from financial innovation will be companies, and families, that have complex finances. Banks already show signs of losing interest in people who want just plain-vanilla checking accounts. Citibank, for instance, now charges $9.50 a month for checking, plus 50 cents per check written. Fees are waived only for people who have a minimum balance of $6,000 in their combined accounts.

But as incomes and wealth rise, more people will find themselves thrust into the role of asset managers. Businesses, too, will have to become more sophisticated--if only to keep pace with financially innovative rivals.

That's where science comes in. Financial engineers view every investment opportunity as a bundle of separable risks and rewards. Their skill lies in teasing the bundles apart and parceling out components to the investors who will pay the most. A simple example is stripping apart the payment stream from a loan portfolio. Some investors will opt to receive the principal-only portion, while others go for interest-only. The buyers happily pay a tad more to get what they want, which translates into a better deal for the borrowers.

Far from Wall Street, in Minnetonka, Minn., financial engineers at Cargill Inc. are transforming the markets for stuff like eggs and sugar. The $51 billion commodities trader and processor is willing, for instance, to guarantee the price of heat-and-serve airline omelettes to its customers for up to a year. It erases most of its own exposure to a spike in egg prices by artfully combining various financial instruments. (Exactly how, it won't disclose.) Using other risk-reduction techniques, Cargill can lock in a sugar price for sugar producers for up to five years--vs. less than two years in the futures market. "The products that we're preaching about today are going to get much more widely and robustly used five years from now," says David E. Dines, vice-president for commodity risk management products.HURRICANE COMING. Another promising innovation is "live cat," short for live catastrophe coverage. As a hurricane approaches shore, property-casualty insurers can reduce their risk exposure by buying catastrophe-index call options on the Chicago Board of Trade. Option prices change from moment to moment, right along with the wind-speed gauges. If the storm is bad, profits from the options help cover claims payments.

Or look farther ahead, to a problem that periodically keeps homeowners up at night: the possibility of plunging property values in their neighborhoods. If you need to sell at the bottom, you could suffer a huge loss. Within five years, though, you may be able to buy a put option--a bet that prices will fall. If they do, the profit you make on the option will compensate for the loss in value of your house. If prices rise, on the other hand, the put option will expire worthless. But you won't care, assuming that your house's price appreciates in line with its neighbors. (True, it might not, but few hedges are perfect.)

Yale University economist Robert J. Shiller is trying to enable real estate options trading by creating price indexes for housing. Says Shiller: "Sometimes the reaction we get is, `Why don't people already do this?"'

While the exotic part of the new finance is customization, the biggest improvements may come from cost-cutting. That's surely the case so far:

Annual productivity gains for commercial banks averaged just 0.6% for most of the 1970s, then rose to 2.0% in the 1980s and hit 3.5% in the 1990s, according to the Bureau of Labor Statistics (chart). For instance, in 1977 a secure telex from a bank in New York to one in Hong Kong cost $15. Now, it's about 30 cents. "We're reaping the gains of the technology that everyone was talking about in the early '70s," says Jill M. Considine, president of the New York Clearing House Assn., which coordinates bank payments.

Firms that sell services aren't the only ones getting streamlined. So are the finance departments of corporations. Hackett Group of Hudson, Ohio, calculates that the financial function accounted for just 1.4% of overall corporate expenditures in 1997, down one-third from 2.2% in 1988. World Research Advisory Inc. of Reston, Va., which advises chief financial officers, predicts that within five years, many corporations will outsource not only tax and audit duties but also planning, budgeting, evaluation--even competitor analysis and M&A.

Some of the biggest savings in the coming decade are likely to come from a reduction in America's wasteful reliance on paper checks. Checks, which are trucked and flown from bank to bank, cost two to three times as much to process as electronic payments, such as with credit cards. Florida State University finance professor David B. Humphrey predicts that the proportion of electronic payments in the U.S. will grow from 24% in 1995 to 58% in 2010. That could really help the economy. Says John R. Mohr, executive vice-president of the New York Clearing House: "Something like half a percent to 1% of GDP is used to support the operation of the payment system. With fewer checks, that could be cut in half."

The Internet will be another force for change. Piper Jaffray Inc., a Minneapolis brokerage, figures the average commission per trade at the top 10 online trading firms has sunk like a stone, from $52.89 in early 1996 to $15.77 in early 1998. Further drops are in store. As costs fall, so do prices: The underwriting spreads on common stock issues dropped to 6.08% last year from 6.47% in 1990, according to Securities Data Co.

Among the biggest losers will be floor traders and specialists. They're like John Henry, who died trying to outdo a steam drill. With gigabit computer networks crisscrossing the oceans, it is possible to bring together all the world's interest in a particular stock, bond, currency, or derivative at a single point in cyberspace. There, a supercomputer can match buyers and sellers at light speed and infinitesimally narrow spreads.FOR A SONG. The writing is on the wall: Seat prices have fallen 50% from their highs on the Chicago Board of Trade and a colossal two-thirds at the Chicago Mercantile Exchange. Even the New York Stock Exchange has seen a one-third decline in seat prices from a record $2 million earlier this year.

Of course, some sectors are doing just fine. Profits of Merrill Lynch & Co., for instance, have more than quadrupled since 1988. And commercial banks, which were on their knees during the recession in 1991, are having one of their best decades ever (chart). The Federal Reserve reported recently that banks' net interest margin between lending rates and borrowing costs has actually been widening, from about 3.5% in the mid-1970s to about 4.3% in recent years.

But even for them, competition is mounting. The threat is not "disintermediation"--there will always be a need for someone to represent investors' interests, making sure borrowers and stock issuers make good use of the money they're entrusted with. The question is whether the intermediary's role will be played by today's bankers and insurers or someone else. New intermediaries include rating agencies such as Standard & Poor's Corp., a unit of BUSINESS WEEK publisher The McGraw-Hill Companies Inc., which enable rated borrowers to go straight to the capital markets instead of appealing to loan officers.

The only true disintermediation is when the owners and the managers are the same people--that is, in a privately held company. Scholes argues that financial technology will make it easier for companies to become private or remain so. They will insure themselves through hedging in the futures and options markets. And by reducing their risks, they will need less of a safety cushion of equity. Scholes cites Cargill as a company that has managed to remain private through hedging. Said Scholes in his Nobel lecture: "I believe the corporate form we know today will not be long-lived."

It has been quite a while since the days of green eyeshades and No.2 pencils. Says Jerry F. Gollnick, president of Tulsa's Williams Energy Services Co.: "I used to say this business wasn't rocket science. But then we hired somebody from the Jet Propulsion Laboratory." Innovation is everywhere.By Peter Coy in New YorkReturn to top

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