Securitization

Securitization enables income streams of pooled loans, reducing overall risk to lenders. This spreads the risk of both prepayments and defaults, lowering the cost of credit.

Background

Denmark created pooled mortgages, called covered bonds, in 1850. Switzerland followed in 1930.

In 1970 US government pseudo-agency Ginnie Mae (GNMA) created the first securitized pool of home mortgage loans. GNMA pooled home loans explicitly backed by the US government; typically loans for military veterans, farmers, or other public-policy types.

Another pseudo-US government-owned company, Fannie Mae, issued the first collateralized mortgage obligation in 1983. Louis “Lou” Ranieri, who started his Wall Street career in the mailroom, famously enabled that first bundle of loans.

These early securitizations existed to manage prepayment risk. That is, banks rely on payments over a long period at a set interest rate. If interest rates decrease, and many people refinance and pay off their loans, the assumptions prove incorrect. Pooling the loans lowered overall prepayment risk.

Michael Milken

Subsequently, Michael Milken, an employee with the Drexel Burnham Lambert investment bank, reworked securitization to diversify default risk, not just prepayment risk. Pooling enabled Milken to sell otherwise high-risk “junk” debt because the risk of default was spread. Ranieri followed up w/ MBS’s that diversified both prepayment and default risk.

Milken’s securitizations enabled financiers to purchase businesses with debt eventually assigned to the business. Oftentimes, existing management opposed these purchases, called colloquially “hostile takeovers.” New management, burdened with the new debt required to acquire the company, thenslashed costs by laying off workers and selling assets. Notable hostile takeovers include Pan American World Airways (Pan Am), Revlon, RJR Nabisco. Bankers engaged in hostile takeovers were known as “raiders”. Over time, the name evolved to the more tasteful “private equity.”

Louis Ranieri Mortgage-Backed Securities

Mortgage securitizations grew steadily larger and more complex over time. Eventually, bankers believed they could mitigate virtually any risk of prepayment or default, extending credit to virtually any borrower no matter the risk. Subsequently, this led to irresponsible lending (and borrowing) which, combined with a type of derivative insuring the securitizations (“credit default swaps”) caused the Great Recession of 2008.

Modern securitizations encompass an enormous amount of the world banking system. They manage prepayment and default risk for every imaginable rent stream and also recapitalize early lenders. The securitization market is so large it been labeled a “shadow banking system” due to the immense amount of capital involved.

Spreadsheet

Spreadsheets simplify calculations and basic database work.

Background

During a lecture at Harvard Business School, in 1978, student Dan Bricklin watched his professor struggle to erase and rewrite cells in a blackboard-based ledger. Thinking about the newly popular Apple II computer Bricklin thought of a better way, a program that allowed users to enter and manipulate numbers.

Bricklin partnered with software engineer Bob Frankston and formed a company on Jan. 2, 1979, to create VisiCalc, the first spreadsheet.

Early reviews raved about the new software:

“Today, virtually the only user of personal computers who is satisfied with the state of the software is the hobbyist. But for the professional, the home computer user, the small businessman, and the educator, there is precious little software available that is practical, useful, universal, and reliable…

Enter Visicalc. What is about to come on the market is a new concept in software that could well go a long way toward fulfilling those aforementioned needs of professionals and alleviating their frustrations… Though hard to describe in words, Visicalc comes alive visually. In minutes, people who have never used a computer are writing and using programs… You simply write on this so-called electronic blackboard what you would like it to do – and it does it.”

Morgan Stanley Electronics Letter, by Benjamin M. Rosen

A Killer App

VisiCalc ran exclusively on the Apple II for years. It was wildly popular. Businesses would buy Apple computers solely to run VisiCalc. Eventually, competing spreadsheet Lotus 1-2-3 addressed many shortcomings of VisiCalc. Sales declined to negligible numbers. Lotus purchased VisiCalc in 1985 and immediately discontinued the program. Subsequently, Microsoft released Excel and, over time, destroyed Lotus 1-2-3 sales, eventually buying the company and shuttering it, much like they did to Bricklin.

“There have been two real explosions that have propelled the industry forward. The first one really happened in 1977, and it was the spreadsheet. I remember when Dan Fylstra, who ran the company that marketed the first spreadsheet, walked into my office at Apple one day and pulled out this disk from his vest pocket and said, ‘I have this incredible new program – I call it a Visual Calculator,’ and it became VisiCalc. And that’s what really drove – propelled – the Apple II to the success it achieved.”

Steve Jobs

Index Investment Funds

“Don’t look for the needle in the haystack. Just buy the haystack!”

Index investment funds are simpler and vastly less expensive than individual stock picking. Firms mimic index funds which, themselves, are created to mimic market strength. Not only do 85 percent of hedge fund managers trail returns in the S&P 500 but also they have underperformed for a decade.

John Bogle started the Vanguard 500 fund, tracking the Standard & Poor’s (S&P) 500 index, in 1977. It quickly grew to become one of the world’s largest funds.

Bogle’s fund always matched the market with minuscule fees due to the absence of expensive (and often incorrect) stock pickers. Therefore, there were also lower taxes due to lower capital gains because firms are seldom rotated in and out of the indexes.

John McQuown and David Booth of Wells Fargo also had an early index fund, in 1973, but it was open only to institutional clients.

“The greatest enemy of a good plan is the dream of a perfect plan. Stick to the good plan.”

Automated Teller Machine (ATM)

Automated Teller Machines (ATM’s) dispense cash, take deposits, and perform other limited banking functions 24×7.

In 1964, James Goodfellow patented and created a machine that used a punched card combined with a secret PIN. He built this out into a full-fledged ATM, filing a patent on May 2, 1966. Later ATM makers, including NCR, licensed his patents. Luther Simjian has represented he invented the ATM earlier, in 1939, and there are press reports of his “Bankograph” machine being used in NYC in 1961. However, his system was more of a vending machine than an ATM.

On June 27, 1967, Barclays Bank demonstrated the first use of an ATM. It used special checks for security. No sooner did Barclays attract attention than, within a month, two other banks demonstrated ATMs. Both used entirely different systems. Some literature posits that the Barclays claim is false and that the system never worked. They claim it was Midland Bank, using equipment made by Chubb, that deployed the first real ATM on July 31, 1967.

Eventually, by the early 1970s, there were countless different ATM’s, with many claiming they were the first. Different firms applied for various patents, with none locking in the entire innovation.

In 1973, the US granted a patent to Donald Wetzel of Docutel. Significantly, Wetzel’s Docutel machine networked, making it more useful than prior single-bank machines. Additionally, it also accepted deposits. However, Docutel machines were expensive, clunky, and used a proprietary stripe so the cards did not work with other ATM’s: by the 1980s the company was out of business. Today there are dozens of ATM manufacturers.

Barcodes & Universal Product Code (UPC)

Barcodes and UPC:

  • Vastly sped checkout times.
  • Reduced the number of staff and training required and the risk of the wrong price being rung.
  • Increased the ability to electronically manage inventory, lowering carrying cost and spoilage risk.
  • Enabled Just-In-Time ordering and itemized invoices.
  • Transformed market research, enabling “big data” studies about items purchased together and which items are purchased in various geographies, at various times, and (when coupled with loyalty cards) by which customers.

Early History

Bernard Silver quit his job after hearing the need, from a grocer, for a better way to manage innovatory and imagining the barcode. He worked with Woodland, who was employed by IBM. Eventually, the two ー inspired by Morse Code ー invented the barcode, a series of dashes and dots to electronically identify items. They patented the innovation Oct. 20, 1949.

Woodland, loyal to his employer, urged IBM to commercialize the technology but they passed. IBM sold the patent to Philco in 1952 for $15,000, which later sold it to RCA, that went on to commercialize barcodes. Silver died in 1963, at age 38.

Barcodes had no known commercial uptake until patents expired in 1969. Eventually, a group of supermarkets banded together to hire McKinsey. They jointly developed the Universal Product Code (UPC).

IBM tasked Woodland, who still worked there, to work with the group developing the UPC.

The UPC identifies every version of every product in barcode form, allowing computers to quickly lookup the product name and price in a computer, the now-familiar checkout process. Laser technology, the bright beam of light, makes modern barcode reading possible.

To encourage adoption of the UPC, IBM agreed to put their barcode patents in the public domain, which they did.

McKinsey’s Wilson implies that IBM and others went on to file new patents, involving the use of the UPC, violating the spirit if not the letter of their agreement.

Barcodes Evolve

There were several competing barcode types in the early days but the now-familiar horizontal bars won out. The original barcode looked more like a bullseye. In 1973, the grocery consortia adopted the modern barcode and UPC as a standard.

Barcodes Become Ubiquitous

Troy’s Marsh Supermarket, in Ohio, is the site of the first barcode being run-up on June 26, 1974.

McKinsey estimated that, for UPC to work, nearly every product would need a UPC barcode before supermarkets would adopt the technology. They found that, in hindsight, the technology lowered cost and increased convenience so much that stores would adopt the technology when about two-thirds of products had UPC codes.

Venture Capital

“There have been many fine scientists desperately trying to become poor businessmen.”

Georges Doriot

Venture Capital pools resources and spreads risk and reward across multiple companies. This simplifies early-stage investing and makes early-stage investing more convenient for both investors and entrepreneurs.

Background

General Georges Doriot is the “father of venture capital.” In 1946, he created the first modern venture capital firm, American Research & Development Corporation (ARD). Eventually, he listed it on the New York Stock Exchange.

Doriot is widely regarded as a founder of Silicon Valley despite that he never visited the region. Individual wealthy patrons typically funded startups before Doriot’s ARD.

Besides ARD, Doriot was a Professor and Dean at Harvard Business School for 50 years, from 1926-1966. Later in life, he also founded INSEAD. During WWII, Doriot took US citizenship, joined the army, and rose to the rank of General working in the military planning division.

Among ARD’s other VC investments, in 1957 Doriot purchased 70% of Digital Equipment Corporation (DEC) for $70,000. Eventually, in 1967, that investment alone was worth $183 million.

Doriot Struggles with Regulators

Regulators forced ARD to sell their DEC stock, arguing a VC firm could not hold founders’ stock for more than ten years. Oddly, they could buy and hold stock in companies they did not initially fund.

US Securities & Exchange Commission (SEC) regulations at the time forbid VC principles from holding stock options in their firms so Doriot, and other ARD principles, made little profit personally.

Finally, the SEC ruled no company that received investment from ARD could issue employee stock options. Since this meant no company would accept an investment from ARD the ruling effectively shuttered the firm and forced Doriot to sell it in Jan. 1972.

Venture Capital Flourishes

In 1959, Doriot student Gen. William Henry Draper started the first VC partnership, Draper, Gaither & Anderson, in Palo Alto, CA. Another notable student of Doriot’s is Thomas Perkins, co-found of Kleiner-Perkins. Arthur Rock, another student of Doriot’s, funded Fairchild Semiconductor and Apple.

Eventually, under President Carter, the SEC the rules to enable modern VC companies. Virtually all venture capital firms today remain privately held.

“Never go into venture capital if you want a peaceful life.”

Georges Doriot

Credit Card

Merchants have always issued credit in one form or another directly to customers. But the idea that a bank would issue credit to purchase anything then, eventually, collect from their customer is newer.

In 1946, after WWII, John C. Biggins invented the first universal credit card, called “Charg-It.” However, the card only worked at participating stores within two blocks of his employer, the Flatbush Bank of Brooklyn, NY.

Eventually, Frank McNamara invented a widely accepted card, Diners Club, in 1950. McNamara worked at a commercial credit company, Hamilton Credit. Diners Club charged customers a 7-percent per transaction fee to use the card.

Manhattan restaurants quickly adopted the card because it allowed diners to pay without worrying about cash, simplifying the dining experience. Restaurants often offered a 10-percent discount for using the card, to lure customers. This 10-percent discount more than offset the cards 7-percent fee. Eventually, credit card companies simply charged merchants a fee to accept the cards.

A decade later, Diners Club had 42,000 customers and 330 establishments accepted the card. However, a new entrant was on the rise. Bank of America released the Bank Americard in 1958. Their card was later renamed visa. American Express also opened in 1958.

McNamara sold his interest in Diners Club to Alfred Bloomingdale in 1952. He quickly built a real-estate empire that just as quickly went bust. McNamara, the inventor of one of the most profitable types of financial technology in history, lost everything and died of a heart attack, bankrupt, in 1957.

Ron Klein, who invented the magnetic stripe for the credit card, also made no money from that innovation. It’s unknown what happened to Biggins besides that he died in 1971, at age 61, and his obituary mentions the early credit-card.

Game Theory

Game theory serves as the foundation of systematized decisionmaking and modern economics.

Indeed, Minimax game theory underlies modern economics and is responsible for countless economic insights, many of which won Nobel Prizes.

Besides game theory, von Neumann eventually modeled the lenses behind the Los Alamos plutonium nuclear bomb.

As a Jewish refugee from Europe whose home country was occupied by the Soviets, von Neumann was a vehement anti-fascist and anti-communist. Eventually, he used game theory to urge the US to destroy the Soviet Union with nuclear weapons.

“If you say why not bomb [the Soviets] tomorrow, I say, why not today? If you say today at five o’clock, I say why not one o’clock?”

John von Neumann, 1950

Like many involved in early nuclear work, von Neumann died young, from cancer, at 53.

Niche Marketing

Walker, daughter of freed slaves, is the first self-made millionaire woman and the first self-made millionaire African American (maybe – tax returns suggest it was $600K but she did very well for herself). She invented beauty products for Black people.

Walker was born in a sharecropper’s cabin. She is orphaned at seven. A freelance launderer, she married at 14, is a mother at 17, and a widow at 20. She never attended school but self-taught herself to read.

At 35 she is still a freelance launderer but bald; her hair fell out. Pope figured out this was due to the use of goose fat and other meat-based products, and strong soaps, that Black women used to style their hair. Pope who set up a hair products company and hired Breedlove as an early sales agent.

Breedlove, by then in her late 30’s (the average lifespan for non-white women was 35 years), formed her own company. She claimed to have invented her own beauty products from scratch using money from sales commissions.

Flamboyant and well dressed, Breedlove always focused on selling. She gave generously and openly to charities. At one point, a $10,000 gift to the then young NAACP was the largest donation in its young history. Sales and charity fundraising determined commissions.

“I am a woman who came from the cotton fields of the South. From there I was promoted to the washtub. From there I was promoted to the cook kitchen. And from there I promoted myself into the business of manufacturing hair goods and preparations. I have built my own factory on my own ground…”

Sarah Breedlove “C.J.” Walker

Branch Banking

Branch banking allows ordinary people to utilize banks and theoretically makes banks safer since larger banks are less prone to catastrophic losses than smaller banks.

Amadeo Pietro “A.P.” Giannini started life as a fruit wholesaler. He built and sold a large business, decided he was too young to retire, then innovated an entirely new type of bank.

Background

While in the fruit business he had routinely extended credit to farmers waiting for their crops to mature and decided to open a bank for ordinary people that could offer even small bridge loans, a new concept at the time. Giannini started the Bank of Italy when he was 34 years old, which was relatively well into middle-age for the time. He had no background in banking at all.

Giannini’s renamed Bank of America was a bank for ordinary people rather than the wealthy and elite. His bank was open longer hours and on weekends, recognizing that people were at work during normal banking hours. He also advertised both banking and loan availability, offending other bankers at the time who thought it gauche.

Giannini’s push to open ever-more branches, eventually spanning the entire US, was an innovation. At the time the belief was that a large number of small banks would prove safer, because if one was reckless customers would go elsewhere. Giannini argued the opposite, that large banks were safer because they could better absorb the risk of a bad decision. Further, because of their large size, they could take more risks and not worry that one bad deal would destroy the bank. In this regard, he arguably created the Too Big To Fail Bank.

Expansion

Bank of Italy charged less interest than the small, independent banks. The Federal Reserve Prime Rate was 5%; small banks would charge 12%, Giannini would typically charge 7%. Giannini utilized leverage at a much higher rate than other banks.

In 1927, Giannini purchased 100 new banks giving him 276 branches in 199 localities and changed the name from Bank of Italy to Bank of America. Because banks were limited state-by-state at the time, he had to create a holding company for each state’s banks, the Transamerica Corporation.

Giannini died in 1949, aged 79, with an estate worth $489,278. By then, BOA was enormous, the large bank in the US. Many of his shareholders were worth much more. Historians say that Giannini had no interest in earning a large fortune for himself, only in building an enormous bank. When he died, BOA employees owned about 40 percent of the stock.