Origins of Value: The Financial Innovations that Created Modern Capital Markets

1. Origins of Value:The Financial Innovations that Created Modern Capital Markets William N. Goetzmann K. Geert Rouwenhorst Yale School of Management

2. History of Financial Innovation • Where and when did the securities and financial contracts exist today originate? • Collaboration among Historians, Economists, and Finance professors • Different perspectives on finance and society

3. Financial Foundations Time Chance Markets Companies

4. Time Finance transfers value through time. Loan is an exchange of value through time Stock shares are future dividends. Futures are pre-agreed compensation for delivered commodities. Institutions for inter-temporal transfer: Family, Bank, Pension, Fund, Government, Non-profits, Contracts, Companies. Institution not as important as the function.

5. Chance Future is uncertain Contract on outcomes Fire, market drop, catastrophe Options, insurance Allow risk-sharing and control of the effect of uncertainty “Structured” risk parcels it out to highest bidders. Current crisis caused by risk aggregation

6. Markets Provides broad access to financial technology. Allows “comparison shopping.” Allows transferability -- creates liquidity. Efficiency of allocation. Prices reveal consensus market beliefs and forces. The expectation of future liquidity creates immediate value.

7. Companies 7 Separation of governance and enterprise. Allows innovation and risk-taking. Constantly creates benefits and challenges.

8. Early Financial History 8

9. Mesopotamia Finance created first writing Cities Central planning Accounting Local and distant trade. Contracts: Loans, partnerships, mortgages, futures. 9 9

10. A contract for future delivery – records the promise to deliver wooden objects and silver in the future. 19th Century B.C.

11. China Coins & monetary policy Loans (Warring States Period) Paper money (Song) Checks and exchange bills (Song) 11 11

12. Loans, 1000 B.C. 15th century Bonds are Stocks (or “sticks”) Bamboo loan tallies Lender and borrower held identical pieces

13. Pawn shops, 700 A.D.

14. Song Dynasty Government Voucher for 500 Wen issued in 1208. Great Ming Universally Circulating Treasury Note, after 1375 A.D. Yale University Collection.

15. First Bond Market, Venice 1172

16. Monte di Pieta Florentine Bond

17. Corporations 17

18. Rome Malmendier “Societas Publicanorum”

19. Amsterdam Exchange

20. VOC (1602) Bond and Share

21. Debt and Structured Finance

22. Bonds and Survival 1648 Perpetuity

23. Tontines • Pension Securitization • A financial innovation that did not survive. • Annuity paid to a group of people to be divided among the surviving members • Used by governments but also organized privately in the form of a private pension fund • Private Tontines require collateral in absence of power of taxation. (Bonds and/or Stocks (portfolio)) • Private tontines start to look like “pension funds”

24. Auditing and Interest Payments of Tontines Back Coupon Front

25. Securitization Mortgage Bonds III Those who furnished money have authorized (…) to issue bonds and provide funds to plantation owners against collateral of their plantations, including slaves, horses, animals, and equipment. IV For security of the investors, the owners are committed to consign all products from the plantation (..) for sale at the greatest gain upon arrival.

26. First (?) Mutual FundEendragt Maakt Magt (1773) • Closed-end Bond Fund • 1% management Fee • Embedded Lottery • Portfolio • Danish and Viennese banks • Danish Tolls and Holstein • Russia and Sweden • Brunswick and Mecklenburg • Postal services of Saxony • Spanish Canals of Taouste and Imperial • British Colonies • Essequebo • Berbice • Danish American Islands

27. Second Mutual Fund and DiversificationVoordeelig and Voorsigtig (1776) (It is prudent) … to spread as much as possible monies over good and solid securities. Because nothing is completely certain but subject to fluctuations, it is dangerous for people to allocate their capital to a single or a small number of securities. Not everyone has the opportunity to invest his money in a variety of securities (…). For the sum of 525 Guilders one can participate in this negotiatie (...), which will be profitable with sufficient certainty. No one has reason to expect that all securities in this negotiatie will cease to pay off at the same time, and the entire capital be lost. If one had reason to fear such general bankruptcy, one never ought to invest any money.”

28. Value InvestingConcordia Res Parvae Crescunt – 1779 The fund will invest in “…solid securities and those that based on decline in their price would merit speculation and could be purchased below their intrinsic values, (…) of which one has every reason to expect an important benefit”

29. Wealth Management and Fraud All securities of the fund …. “…..will be placed under the custody of the notary public in iron chests with three differently constructed locks and the key of one will be confided to his care, and those of the two others to that of the two directors of the fund” Concordia Res Parvae Crescunt 1779

30. First Commodities Bondaddressing inflation concerns Excerpt from the terms: Both Principal and Interest to be paid in the then current money of said state, in a greater or less sum, according as Five Bushels of CORN, sixty-eight Pounds and four-seventh parts of a pound of BEEF, Ten pounds of SHEEPSWOOL, and sixteen pounds of SOLE LEATHER shall then cost, more or less than One Hundred and Thirty Pounds current money at the then current prices of said articles.

31. Financing the American Revolution and the collection of interest

32. Collecting Interest on Illiquid Debt Issued by Russia

33. Securitization of Russian DebtEarly 19th Century Depository Receipts

34. Securitizing LivesandDiversification of Mortality Risk Names of young girls