How Financial Innovation Can Save the World

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The new lords of finance come, not to bury capitalism, but to refine it

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Financial innovation got a bad rep in the financial crisis. But inside the well-barricaded Federal Reserve Bank in downtown San Francisco last month, the financial engineers were at it again.

Teams of financial statistical whiz kids pitched complex new bonds, loan-guarantees, and hybrid structures of debt and equity. Their target? It wasn't mortgages. It was women's economic empowerment. It was energy efficiency improvements and ranchland conservation. It was small businesses in Africa.

The Occupy movement has tarred Wall Street with a broad brush, while economists like Yale's Robert Shiller have tried to rescue finance from the consequences of its excesses. At the Fed, the MBA students competing in the second International Impact Investing Challenge were part of a new crop of financial engineers taking a different tack: tweaking risk and reward to directly tap at least a small part of the $60 trillion private capital markets for positive, measurable social impact.

The contest winners, who come from Stanford, have a plan to bring electricity to remote Indonesian islands -- and 5 to 7 percent returns to investors -- by financing local micro-grids through special-purpose vehicles owned jointly with community co-ops. The runners-up, from the Kellogg School of Management at Northwestern, aimed to help slum dwellers in Mumbai get higher-paying jobs, financing job-training by offering private investors 7 percent of graduates' paychecks for two years.

"These are not idealistic kids," the mastermind of the contest, David Chen, CEO of Equilibrium Capital Group LLC in Portland, Ore., said of the student financiers. "They are making a judgment call on the future. This is the equivalent of investing in hedging strategies or emerging markets, or high-tech 25 years ago. In each of those cases, the market efficiency and information efficiency gains went to those that were first."

HIGH FINANCE FINDS A HEART

"Impact investing" is catching on among investors who want to use finance to make more food, cleaner water, better health care, smarter children, and a richer bottom-of-the-pyramid. Morgan Stanley has an "investing with impact" offer for its wealthiest customers, and AOL founder Steve Case told The Economist that impact investing was the hottest topic of conversation among a group of billionaires gathered in Santa Barbara.

In the broadest view, impact investors are simply betting on fundamental trends. In a volatile and resource-constrained world, investments to provide food, water, energy, health care, education and sanitation to a growing and increasingly affluent global population arguably have lower risks and higher long-term returns. But on the ground, even innovative efforts to meet basic needs often are hampered by inefficiencies and market failures that prevent those who create value from getting paid for it.

Enter the financial innovators.

If J.P. Morgan can use credit default swaps to bet that corporate credit ratings would rise in a volatile economy, why not let other investors use newfangled investment vehicles to bet that job training can keep ex-offenders from returning to prison or that transitional housing can reduce the ranks of the chronically homeless? The savings to governments in unbuilt prisons and unfilled beds in homeless shelters could be significant.

HOW FINANCE CAN REDUCE CRIME

A British import offers a way to collateralize such win-wins. "Social impact bonds," sometimes called pay-for-success contracts, let private investors buy low-interest bonds to finance preventive efforts and get repaid, with a small premium, from those government savings. The new bonds effectively leverage the value of prevention, an ounce of which, Benjamin Franklin taught us, is worth a pound of cure.

If the social interventions meet its benchmark, a government agency pays off the bondholders out of the substantial savings from lower costs associated with jail-time, nursing homes and emergency room costs. If the programs flop, too bad. Budget-crunched agencies pay only for what works.

So far, exactly one such bond has been issued, to be repaid by the U.K Ministry of Justice if re-entry services for released prisoners lowers their recidivism rate by at least 7.5 percent. But Massachusetts is getting ready to back bonds to finance housing and other services for the chronically homeless, to improve their well-being, and reduce Medicaid costs. The Labor Department is committing $20 million for pay-for-success contracts for state-level workforce development; the Justice Department is backing contracts for prisoner re-entry programs.

"We hope to show that you can securitize a new form of cash flow out of government savings based on the spread between prevention and cure," says Tracy Palandjian, who heads Social Finance, the Boston-based nonprofit that is organizing a number of demonstration efforts.

If it sounds sketchy, consider that financing methods we now take for granted were once edgy as well. The 30-year amortized mortgage was introduced by the Federal Housing Administration in the 1930s to unlock bank lending during the Depression. In the late 1970s, federal regulators let pension fund fiduciaries invest in venture capital, fueling the tech explosion.

CAN "MORAL" FINANCE REALLY MAKE MONEY?

Now there's a rush to "crack the code" for unlocking private capital to meet the needs of the world's poor. For example:

-- The government's Overseas Private Investment Corp., or OPIC, agreed to put down $285 million last year in a half-dozen "impact" funds that pledged to raise another $590 million in private capital.

-- The Small Business Administration has committed $1 billion over five years to finance job-creation in low-income communities and clean energy projects, matched by private capital.

-- In the UK, the Big Society Fund launched recently with 600 million pounds (more than $950 million) to invest in social enterprises. Two-thirds of the money comes from dormant bank accounts reclaimed by the government and the rest from four big banks.

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David Bank, a former reporter for the Wall Street Journal and vice president of Civic Ventures, is developing ImpactIQ, a news and data service for impact investors.

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