Fault lines: how hid­den frac­tures still threaten the world econ­omy

The Smart Manager - - Reading Room - By raghu­ram g ra­jan

When the French monar­chy was strapped for money in the eigh­teenth cen­tury, it found more and more cre­ative ways to raise funds.1 One of these was to sell an­nu­ities—gov­ern­ment bonds that paid out a fixed amount un­til the death of the per­son on whom the an­nu­ity was writ­ten. An­nu­ities were very pop­u­lar with the pub­lic, for they of­fered ben­e­fi­cia­ries a guar­an­teed in­come for life in a time be­fore there were old-age pen­sions. The monar­chy liked them be­cause it re­ceived pay­ment up front.

The monar­chy tar­geted these an­nu­ities at wealthy men—typ­i­cally in their early fifties—who had the means to buy an an­nu­ity and who, given low life ex­pectan­cies at that time, typ­i­cally did not have very long to live. An­nu­ities were priced so that they were a fair deal for such men. How­ever, it was pos­si­ble for the buyer of the an­nu­ity to make the pay­ments de­pen­dent not on his own life span, but on that of some­one else. Per­haps this loop­hole was not in­ad­ver­tent, for it in­creased de­mand for the an­nu­ities: for ex­am­ple, it might have made an­nu­ities at­trac­tive to a wealthy mer­chant who wanted to set­tle his daugh­ters for life. But it did mean that the clever in­vestor could make money off the gov­ern­ment. He could pick as ben­e­fi­cia­ries healthy young girls (then as now, women lived longer than men) whose fam­ily his­tory sug­gested a ge­netic pre­dis­po­si­tion to long life, and who had sur­vived early child­hood (in­fant mor­tal­ity was very high in those times) as well as the dreaded small­pox. He could then buy an­nu­ities on their lives from the French gov­ern­ment. A care­fully se­lected, healthy ten-year-old girl would have much higher odds of sur­viv­ing for a long time than the typ­i­cal ben­e­fi­ciary of the an­nu­ity, and the pay­ments re­ceived dur­ing her life­time would far ex­ceed the cost of the an­nu­ity.

This is in­deed what a group of Geneva bankers did. They se­lected groups of thirty suit­able girls in Geneva and pur­chased a life an­nu­ity on each from the French gov­ern­ment. They then pooled the an­nu­ities so as to di­ver­sify the risk of ac­ci­den­tal early mor­tal­ity among the girls and sold claims on the re­sult­ing cash in­flows to fel­low cit­i­zens of Geneva. This early form of se­cu­ri­ti­za­tion thus al­lowed the bankers to cre­ate a vir­tual money ma­chine, buy­ing poli­cies cheaply from the French gov­ern­ment and re­selling them for a higher price to in­vestors. The in­vest­ments were pop­u­lar— es­pe­cially be­cause the bankers were

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