Financial Technology Archives : Innowiki

Reasonably Priced Business Computer (IBM/360)

The IBM/360 is the first mass computer, designed as a general-purpose computer affordable for mid-sized businesses yet powerful enough for large enterprises.

Background

In 1962, IBM’s revenue was $2.5 billion. CEO Thomas Watson Jr. believed in the vision of a general-purpose computer that supports timesharing, the ability of a computer to do multiple things at once. Thereafter, he invested a staggering $5 billion ($42.5 billion adjusted to 2019), double the company’s annual revenue, to develop the IBM/360. Indeed, more than 100,000 people scattered over 165 cities worked together to create the IBM/360.

One key feature of the IBM/360 was forward and backward compatibility, along with upgradability. Before the IBM/360, businesses purchased a computer and, when they outgrew it, purchased a new computer. In contrast, the IBM/360 enabled extra peripherals, increasing the capacity of the computer. Additionally, a significant amount of older IBM software ran on an emulator.

Prior to the IBM/360, computers were typically custom-tailored to the task at hand. Scientific computers were different than business computers. Additionally, a computer to run an accounting system was different than a computer to run inventory management. Much like Intel created a general-purpose microchip, IBM created a general-purpose overall computer.

The IBM/360 is one of the few computers that both sit in the Computer History Museum and is still in use, 55 years after its introduction. Even though the vast majority of smartphones contain more computing power and memory, the 360 oftentimes does one task, do it well, and have done it for decades. Businesses should move the tasks to newer computers but the 360 is so reliable that migration is oftentimes a low priority.

Third-Party Peripheral Market

Besides forward and backward combability with other computers, IBM allowed third-party companies to create certified peripherals for the 360. While this idea seems common now, it was a groundbreaking experiment when the 360 launched. “Half a million saved is half a million earned,” read third-party peripheral makers advertising low-cost high-quality add-on’s.

Success

The IBM/360 was incredibly successful. IBM was unable to keep up with orders for years. Eventually, even the Soviet Union copied it and named their System/360 knockoff the “Ryad” computer. By 1989, the 360 and successor computers accounted for more than $130 billion in annual revenue.

Long-Term Mortgages

Mortgages are loans to purchase a property. The word derives from the French “mort” and meant death pledge with the obligation ending when the loan was paid off or the property repossessed.

Background

The Dutch have the earliest mortgages. Originally in the Netherlands, people saved money and purchased their house for cash. However, starting in the 1800s, people would borrow money from one another. These peer-to-peer lending schemes functioned well and increased homeownership.

Eventually, the Netherlands came to view homeownership as good public policy and established specialized mortgage banks. In the 1850s, Dutch mortgage banks financed the purchase of homes by selling bonds. They’d then lend the funds at .75% above the bond face value as a “servicing fee” for collecting payments remitted to investors. This model eventually evolved into securitization.

The Netherlands continued to expand its mortgage banks. Other countries adopted various lending schemes. In Prussia, credit co-ops called Landschaften arranged for loans though typically to royals. Landschaften were interesting because they were non-profit.

In the US and UK land ownership was for the wealthy who rented on oftentimes terrible terms. The infamous English “Star Chamber” – known for its brutality hearing heresy cases – was primarily a landlord/tenant court. Russian Vladimir Lenin worked as a legal assistant and, some historians believe, focused on landlord-tenant issues. These cases radicalized him, transforming him into the Founding Father of Soviet communism.

Towards Home Ownership

Towards the later 1800s and into the early 1900s mortgage lending in the US and UK became more common. However, in the US most loans were five-year interest-only payment schemes with the full balance due at the end of the loan. Usually, people would refinance to another five-year loan, sometimes paying down more principal if they managed to save. While this system was an improvement over terrible landlords, it was far from optimal.

American mortgages became a serious problem during the Great Depression when home values plummeted. Borrowers were unable to refinance their loans and foreclosures (repossessions) became rampant. As additional repossessed homes were auctioned, and the economy worsened, the price of houses further decreased creating further foreclosures. American house prices entered a death spiral plunging countless people into homelessness.

Long-Term Mortgages

In 1934, the US government created the Federal Housing Administration to rescue the housing market. The agency guaranteed mortgages under certain terms, encouraging banks to start lending again. One of the terms is that mortgages last the life of the loan. That is, mandatory refinancing was prohibited.

Over time, these long-term mortgages because of the standard in the western world. Asian countries also evolved from cash-only to partial mortgages to western-style mortgage loans. Today, in many Asian countries, long-term mortgages are no longer unusual.

Repo Loans

Repo loans are a type of loan, typically from one bank to another, with a very short term for repayment. One day repo loans are common. Despite the name, “repo loans” have nothing to do with repossessions.

Background

Repo loans came about after the US finally chartered a single, all-powerful central bank in December 1913. Before that time there were two weak US banks, that failed, and countless regional banks.

Let’s step back for a minute. Banks take in deposits and lend money. Some banks, depending upon laws that vary country-to-country (and over time) also invest the money. Banks keep a certain amount of their depositor’s money, called a reserve, and lend or invest the rest.

This usually works fine but if there’s any one day that has the need for more capital than normal, say to complete a deal, banks borrow money for that one day only. Banks who did not have access to these short-term funds could not complete deals which was harmful to the overall economy.

In response, the newly created Federal Reserve created repo loans, to lend banks short-term funds and keep liquidity in the system.

Repo Loans Spread

Soon enough, banks started lending repo loans to other banks and the Federal Reserve, and all other central banks became a bank of last resort. That is, a bank could borrow money from the Federal Reserve but it would be on more onerous terms than other banks, alerting regulators (and, initially, depositors) that a bank was suffering financial distress.

After the Great Depression in the US banks were divided into two types. There were retail banks that held government-guaranteed deposits and loaned money. However, they were extremely restricted in their investment activities. Then there were investment banks that could only work for businesses but could and did invest.

Retail banking became boring. But investment banking was a wild ride. Well-known investment banks included Goldman Sachs, Morgan Stanley, Bear Stearns, and Lehman Brothers.

Bear Stearns famously relied upon one-day repo loans for the vast majority of their liquidity. The bank loans money out on a longer-term higher-interest project and relied on one-day low-interest loans to stay afloat. One day interest rates were low because the risk was perceived as somewhere between low and non-existent: how could a giant bank go out of business overnight?

2008 Financial Crisis

This worked well for decades until the financial crisis when other banks feared that Bear Stearns could, indeed, declare bankruptcy and fail to repay their one-day loans. First, they increased borrowing costs and eventually refused to lend at any rate.

Allegedly worried about financial mayhem, the New York Federal Reserve stepped in. In 2008, Tim Geithner brokered an emergency sale of the bank to the more stable JP Morgan Chase. This signaled the beginning of the financial crisis.

Despite problems in the past, the repo loan market continues to fuel the modern financial world.

Credit Union

Let it not be forgotten that a credit union is, above all else, an association of people, not dollars.
Alphonse Desjardins

Banks at the turn of the 20th century were for rich people. A.P. Giannini founded his Bank of Italy, later renamed Bank of America, in 1904 as a bank for everybody else. But it took Giannini a long time to build to scale and, in the interim, there was nothing else.

History

Banking customers at the time fell into two broad categories. There was a small group of those today we’d call the 1%. They were treated well but there were few of them. Then there was everybody else. They weren’t treated so well: there were sky-high fees, usurious interest rates, and bank tellers who were indifferent at best.

Digression: that sounds a lot like banking today for most people though that’s a different issue, or maybe an opportunity.

Desjardins was Canadian and familiar with the guild-based savings banks in Europe. Summarizing, a group with common interests would pool their savings to make loans to others in their pool who had common interests at reasonable rates. Thanks to underwriting based on personal knowledge and peer pressure defaults were extremely low and, when they happened, unquestionably unavoidable.

Building on the idea of group-based banking with reasonable fees and interest rates, Desjardins brought a similar idea to North America. First, he introduced it to his native Canada then to the larger US market. In essence, people who work in the same area, the same field, or maybe for the same employer create a bank-like entity with low fees and reasonable rates. Rather than a bank, which carried a brand stigma and regulatory issues, he labeled his innovation a credit union.

Banks vs. Credit Unions

One major difference from banks is that credit unions are owned by the depositors, the customers, rather than a third party or anonymous shareholders. Therefore, the goals of the credit union are aligned with the customers of the credit union. Theoretically, there is no demand to maximize shareholder value from credit unions because the customers to be abused are the shareholders.

Credit unions still exist today for the same purpose. As of 2018, the Navy Federal Credit Union has over $90 billion in deposits. The largest private company credit union, for Boeing employees, has about $18 billion in deposits and ranks as the fifth-largest in the US. Credit union exist around the world but are especially in English-speaking countries. To this day, banks routinely attack credit unions as opaque loosely regulated banks that should be shuttered.

Blue Ocean Strategy & Finance: Margin Lending

Margin lending refers to the process of using borrowed money for investing. For example, a traditional investor may purchase 100 shares of a business for $10, spending $1,000. However, using margin, that same person may purchase 150 shares, spending the same $1,000 and borrowing another $500. If the stock price goes up, they pay the loan costs and keep the gains. However, if the price declines, they are forced to sell the stock to pay off the loan. Margin lending is an example of the use of blue ocean strategy in finance.

Early History

Building early railroads was an expensive undertaking and Americans were short liquid capital in the mid-1800s. To finance businesses in the early 1800s, people typically turned to broker Nicholas Biddle of Philadelphia who marketed sterling bonds from the UK. This funding mechanism dried-up with the failure of the Bank of the United States of Pennsylvania in 1841. State Street, in Boston, took over and became the primary financier for railroads. In 1847, a severe recession caused a liquidity crunch that left the bank standing but unable to finance large projects.

Subsequently, lenders turned to New York-based merchants, bankers, and brokers who typically had more capital to make loans. Funds flowed from Wall Street to build railroads in the Southern and Western states.

Brokers considered early railroad bonds low-risk, and they competed to sell bonds. Therefore, they offered to partially finance bond purchases. A person who wished to purchase, say, $500 of railroad bonds could use $250 cash and borrow another $250 with the bond as collateral. This type of funding mechanism, encouraged by the government because it helped build infrastructure, was referred to as a “call loan.”

Margin Lending

Over time the US flourished. Eventually, the stock market became more popular. Brokers and eventually ordinary people used a similar type of call loan. Brokerage houses lent funds to buy stock secured by the stocks as collateral. For example, a person who wished to buy $1,000 of stock might pay for $500 of stock and finance another $500, with the loan secured by the initial $500 block of stock.

Margin loans worked great when stocks went up in value. Using the example above, if the stock price increased by 25% then the stock would be worth $1,250. The person could then sell the stock, use the proceeds to pay off the $500 loan, and realize $250 profit. Without the margin loan, our hypothetical stock buyer could have only purchased $500 of stock that would have increased in value by $125. Margin lending doubled their profits.

Image result for roaring 20s stock market

Margin Mania

By 1929 the US stock market was booming, and everybody was buying stocks. Margin lending requirements were extremely weak; everybody was buying stocks on margin and making lots of money. In the winter of 1928, financier Joseph Kennedy, father of the late President, famously quipped “You know it’s time to sell when shoeshine boys give you stock tips. This bull market is over.”

By this time some brokers were leveraged 10:1. That is, they’d pay $100 and borrow $900 for $1,000 of stock.

When stocks began to drop in price, the underlying collateral securing the margin loans was no longer enough. Subsequently, brokerages made “margin calls.” They demanded margin borrowers sell the underlying stocks to pay down or pay off the loans. This forced selling caused the price of the stock to drop further, setting off further margin calls.

Image result for stock market crash 1929

As the overall market dropped, cascading margin calls and the forced selling caused the market to drop even further. By late October 1929, the stock market all but collapsed with forced and panic selling. A four-day run was the worst percentage decline in US history before or since. WWI cost less than those four days.

Great Depression

Both banks and their customers heavily invested in stocks. Banks also received margin calls. They then used reserve funds (customer deposits) to cover the margin calls. Eventually, the banks ran out of money.

During this era, deposits were uninsured. When a bank went bankrupt depositors lost their money. Therefore, when people heard their bank was in trouble they’d line up to take their funds out before the bank ran out of money, a bank run. As banks paid deposits in cash they’d have fewer reserves necessitating more margin calls, shuttering countless banks.

It wasn’t until June 1933, the US government intervened by creating the Federal Deposit Insurance Corporation to guarantee certain bank funds would be available even in the case a bank failed.

Stock losses, margin calls, and bank runs caused people to withdraw their money and save it. Americans stopped spending for anything besides the most vital goods. This caused retailers to fail, leaving their workforce unemployed and their creditors with unrecoverable debt.

With the economy in dire shape, the US decided to sharply restrict world trade, putting up protectionist barriers. Europe retaliated with their own trade barriers and export markets for US products froze, causing crop prices to drop. Farmers could not repay loans and lost their properties to widespread foreclosures.

Additionally, in an attempt to grow more crops farmers over-farmed their land resulting in widespread erosion and dust storms that destroyed vast amounts of farmland.

The margin lending, bank runs, lack of spending, trade war, and environmental mess led to the Great Depression.

Easy Credit

Background

Cyrus McCormick’s mechanical reaper revolutionalized agriculture. McCormick’s reaper enabled one man to harvest the same amount of grain in one day as he could in two weeks by hand. Since grain goes bad when not timely harvested, the reaper enabled farmers to plant far larger crops with commensurate profits. Additionally, the reaper lowered the price of grain, enabling the booming US population to cost-effectively eat.

His company, McCormick & Odgen (the major of Chicago), grew at a fast pace. Eventually, McCormick bought out Odgen and the McCormick Reaper Company thrived.

However, McCormick faced one major problem; his patent was expiring. In 1848, McCormick entered into an epic showdown with Obed Hussey, who invented and patented a similar reaper before his. After heated litigation, the judge did a Solomon and declared both patents invalid. Countless reaper manufacturers started selling low-cost knockoffs.

In response, McCormick marketed heavily. One of his biggest challenges was a chicken-and-egg problem. Farmers using reapers will realize increased revenue and profit. But, with their smaller farms and crops, reapers were not affordable.

Easy Credit

In response, McCormick came up with a seldom-used strategic move: easy credit. Knowing that the reaper will increase revenue and profit, McCormick extended credit to virtually anybody who wanted a reaper. Since McCormick’s business was already profitable he could afford to do this. However, the myriad of me-too knockoff reaper companies did not have the capital to compete.

McCormick’s strategy was wildly successful. His business, later renamed International Harvester, went on to dominate the field for 150 years. Interestingly, in 1984, International Harvester sold the farming division after suffering enormous losses due to a months-long strike. The CEO responsible for the strike, Archie McCardell, is the same CEO who ignored the Xerox PARC inventions during his time as CEO of Xerox. The Board of Directors fired him the day after the strike finally settled. McCardell was also at the helm of Xerox when Japanese competitors took the bulk of the copier market.

Central Banks

Background

The first central bank was Swedish Riksbank. The Swedish government chartered it to act as a clearinghouse for commerce. In 1694, the Bank of England was founded. It’s primary purpose was to purchase government debt. Napoleon chartered the Banque de France to stabilize currency after the French Revolution.

Early central banks, and their modern counterparts have many functions. One of the best-known is they issue currency and hold a monopoly over money. They also enable non-central banks to operate, issue other banks loans, purchase state debt, create money, and manage inflation.

Controversially, central government-chartered banks can become a lender of last resort during financial crises.

Purpose of central banks

One often misunderstood component is that central banks are private institutions, not unlike other banks. The difference is they enjoy monopoly powers other banks do not – including and especially the ability to issue currency – and their only customers are other banks. Their original customers are other banks. Their only product is short overnight loans. However, most notably during the Financial Crisis of 2007-2008, the US Federal Reserve loaned money directly to bail out banks and private businesses.

While central banks issue currency, most tied their currencies to gold. While the gold standard was abandoned during the 20th century, many central banks still have vast amount of gold. The US Federal Reserve has over 400 tons of gold in the vault under its bank in New York City.

Nevertheless, many central banks print currency tied to nothing, called fiat currency. Other central banks tie their currencies to other fiat currencies or a combination of fiat currencies.

Countries have gone without central banks, but it usually does not end well. The US had an 80-year period with no central bank: states made their own banks which issued their own currency. There were bank runs, massive fraud, and payments took forever to clear as the various individual banks worried about fraud. A financial crisis in 1907 convinced the US government of the need for one central bank and, in 1913, the Federal Reserve was created.

Modern central banks

During the 20th century, central banks added overall economic health to their focus. Before then, their primary goal was to make sure the money supply was stable and ensure payments between banks. They evolved and, today, central banks also try to reduce unemployment and prevent recessions.

The heads of most central banks are economists.

Options & Futures

“I’ll gladly pay you Tuesday for a hamburger today,” cartoon character Wimpy Wellington repeatedly offers. If he worked as an options trader he’d probably say “I’ll gladly pay you 1/10th the price of a hamburger today if I can buy a hamburger, sometime in the next year, at the price they are today.” You’d answer: “but don’t you want to taste the hamburger?” “No,” he’d reply. “I’m a vegetarian but plan to sell my hamburger option to a meat-eater at a profit: I don’t really care about the burger except to the extent somebody will eventually want it.”

The options and futures market is where speculators agree to buy or sell a stock or commodity in the future, at a price set today.

Tulip Mania

The introduction of options and futures almost immediately created the most famous market bubble in history. Tulips were a popular crop from the Netherlands. They’re a perennial plant, grown from bulbs. Prices began to rise when speculators realized they could use options and futures to profit. Most traders purchased options for tulip bulbs, not actual bulbs. Because there was a limited number of plants, others repurchased the options at higher prices.

Eventually, the price of some tulip bulbs was at ten-times the annual wage of a skilled worker. Options and futures fueled the prince increases enabling traders to increase prices far faster than tulip bulbs could be produced. Eventually, the bubble burst and caused enormous losses.

Utility Value

Options and futures were originally created, and are still used, to spread the risk of crop failure. Farmers would sell an option to purchase a crop in the future at a set price.

When the crop matures, the agreed-upon price might be lower than the market price and the farmer is forced to sell at a loss. Conversely, the agreed-upon price might be higher and the option buyer then does not purchase the crop but loses the price they paid for the option. Finally, the crop might fail in which case the farmer received at least some revenue – the price of the option – rather than nothing.

In many ways, options function similar to insurance.

Futures or commodities contracts, or derivatives thereof, make up the bulk of trading today.

Traders don’t want and wouldn’t know what to do with, for example, thousands of tons of wheat, aluminum, or pork bellies. They wouldn’t know what to do with one pork belly, much less a truck full. However, they theoretically bring stability and predictability to those who actually grow and consume various products, except when they don’t.

Multinational Corporation

A Nightmare, in Real Life

Picture the entire Fortune 500 combined into one large company.

The company manufactures everything imaginable with monopolies in cotton, silk, dyes, salts, spices, and tea. Not only do they have near-monopolies in gunpowder but also weaponizes opium, giving away free samples to encourage dependency. Basically, their only moral is to make money.

Government and the company intertwine at the highest levels. Comparatively, their owners make Russian oligarchs look like market stall merchants in wealth and influence. Indeed, the company effectively dictates government policy.

The company raises its own army. It is twice the size of the official army with no legal constraints. They outright colonize other countries and start and fight wars. If they prevail in war then the company keeps the spoils. However, when they lost then government absorbs the losses.

The British East India Company worked exactly like this.

The company was enormous, openly influencing and dictating to the government. Eventually, they controlled half of all trade in Britain.

The East India Company colonized and ruled India. Subsequently, they started and fought the opium wars with China in the name of Britain.

Other East India Companies

There was also a Dutch East India Company that was not entirely dissimilar. That business colonized South Africa, literally enslaving the locals. The Apartheid government is a direct result.

The French East India Company was not nearly as successful, due more to a lack of capital than higher morals. They tried and failed to colonize Madagascar but did create small outposts around the world.

France dissolved their East India Company, which never earned a profit, in 1769. The Dutch East India Company was dissolved in 1799 and all assets and territories became the property of the Dutch government. In 1858, the British government assumed control over the soldiers and territory. The British East India Company dissolved in 1874.

Electronic Stock Exchange (NASDAQ)

History

In early stock markets, traders offered and accepted bids for stock prices to one another. People would stand in a stock exchange and literally yell out stock symbols and prices. Buyers would purchase blocks of stock.

This system was slow and expensive. Only high-level bankers had access to the people on a stock trading floor, and only the wealthiest could afford to buy even the smallest block of stock offered. Therefore, a middleman would broker smaller shares of the bundles to regular people, typically at high fees.

Everybody except the very wealthiest lacked real-time access to the difference between prices offered and accepted, called the spread. This allowed floor brokers to make a profit by exploiting the lack of information.

NASDAQ

Eventually, brokers tired of the lack of transparency and banded together. The National Association of Securities Dealers created a computer-based electronic system to vastly reduce the spread, speed stock transactions, and reduce transaction costs. The system is known by the trade groups acronym, NASD plus Automated Quotations, or AQ (NASDAQ).

Originally, NASDAQ only provided pricing information faster and more accurately than other systems. In 1987, the business spun off from the NASD on its way to becoming a full-fledged exchange rather than an inexpensive stock quotation system.

Due to its all-electronic origins, NASDAQ was especially attractive to burgeoning Silicon Valley companies. Oracle, Microsoft, Apple, and countless other tech companies – plus many non-tech businesses – made an Initial Public Offering (IPO) of stock to the public on NASDAQ. The vast majority continue to trade on the exchange rather than the vastly older New York Stock Exchange (NYSE).

Today, all stocks are traded electronically. The New York Stock Exchange still has a trading floor but openly admits it exists more as a prop. Thirty media companies broadcast from the gilded trading floor and the opening bell ceremony looks cool.