Global Risks: Unhedged or Unhinged

1
Global Risks Unhedged or Unhinged?

• The Outlook for Financial Markets,
• for Their Governance, and for Finance

Glenn Yago Milken Institute October 2009
2
Top Five Risk Factors

• Financial convergence
• United States
• China
• Opacity and capital access risks the hidden
  costs
• Energy, environmental, and catastrophicrisk the
  axis of oil

3
Financial Convergence

• History doesnt repeat itself, but it does
  rhyme.
• -- Mark Twain

4
U.S. Stock Market Plummeted on February 27,
2007 A Market Correction Made in China
The Dow dropped 241 points in 3 minutes
Source Bloomberg
5
Higher Degree of Integration Between NYSE and
Shanghai Stock Exchange
Correlation 0.8773 January 2006 March 2007
Source Bloomberg
6
21st Century Global Equity Market Convergence
Correlation with Dow, 12-Month Rolling Returns
Source Bloomberg
7
Converging Yield to Maturity
Emerging Markets Sovereign Bonds
U.S. Treasury
Source Merrill Lynch
8
Convergence in Sovereign Bond Yields, 1870-1913
40 35 30 25 20 15 10 5 0
1870 1875 1880 1885 1890 1895
1900 1905 1910 1915
Source Michael A. Clemens and Jeffrey G.
Williamson (2004)
9
Increasing International FinancialConvergence
Sum of Foreign Assets and Liabilities as a Ratio
to GDP
Sources Lane and Schmukler and Milken Institute
staff estimates
10
Sources of Funds into Emerging Markets
Source International Monetary Fund
11
Dependency Burden Forecast Dependency Ratio
Developed Countries
Developing Countries
Source United Nations
12
Dependents - Developed Countries Forecast
Dependency Ratio
Source United Nations
13
Dependents - Developing Countries Forecast
Dependency Ratio
Source United Nations
14
U. S. Challenges
15
U.S. Subprime Mortgages Composition of Total
Mortgages Originated
Sources Inside Mortgage Finance and Milken
Institute staff estimates
16
Subprime Problems Drive DownFinancial Stock
Prices The Dow Closed Down 243 Points on March
14, 2007
Source Wall Street Journal
17
Inverted Yield Curve
Source Federal Reserve
18
China
19
Major Contributors to World GDP Growth
Source World Economic Outlook
20
Fixed Investments ContributeMore than 40 to
Chinas GDP Growth
Sources International Financial Statistics and
Bureau of Statistics (China)
21
Composition of Chinas Financial Market
Sources International Financial Statistics, Bank
for International Settlements, and Global Stock
Market Factbook
22
Accumulating Appreciation Pressure on Renminbi
Source International Financial Statistics and
Milken Institute
23
Capital Access and Opacity Risks The Hidden
Costs
24
Banking Crises Since Late 1970s (168 crises in
138 countries)
SourceCaprio, Gerard and Daniela Klingebiel
(2003)
25
Capital Access Index 2006 Gauging
Entrepreneurial Access to Capital
Source Milken Institute
26
Capital Access Index, 2006
Less access
More access
Sources World Economic Outlook and Milken
Institute
27
Improved Capital Access Can Add Billions to
Emerging Economies
28
Cost of Opacity, 2005
Source Milken Institute, 2006
29
Energy, Environmental, and Catastrophic Risks
The Axis of Oil
30
Growth in Oil Demand Outstrips Supply
Sources Bloomberg and BP Statistical Review of
World Energy, 2006
31
Oil Reserves Concentrated inUnstable Regions
Sources Energy Information Administration
32
Volatile Oil and Natural Gas Prices
US dollars per thousand cubic
Sources Energy Information Administration
33
Risky Trading in Energy Markets

• Money invested in energy trading has soared
• Hedge fund Amaranth Advisors LLC collapsed
• Because of ill-timed natural gas futures,
  Amaranth Advisors lost 65 percent in a month and
  55 percent, or 6 billion, for the year
• Investors include not only hedge funds, but also
  endowments and pension funds

Source Washington Post, September 2006
34
A Cost Curve for GHG Reduction
Source The McKinsey Quarterly 2007
35
Catastrophic Risk on the Rise Global Number of
Catastrophic Events, 1979 2004
Sources Allstate Insurance Company
36
Economic Impact of Catastrophes
Sources Allstate Insurance Company
37
Larger Impact on Emerging Market Economies
Sources Allstate Insurance Company
38
Catastrophe (CAT) Bonds
Catastrophe Bonds
39
Terrorist Attacks Are Becoming More Frequent and
More Intensive
Sources MIPT and Milken Institute staff
calculation
40
Financial Innovation Unlocking Value

• What is financial innovation?
• New Products/Services
• New Processes
• New Organizational Forms
• Why is financial innovation important?
• Finance is a central input for virtually all
  productive activity
• Better finance encourages more saving and
  investment
• Better finance encourages improved productivity
  of investment decisions

41
651 Financial Innovations News Stories in WSJ
1990-2002, by Innovation Type
42
Innovators and Patentees Firms that had
greatest number of WSJ stories abut innovation,
99-02
43
Patent Application/Innovation Ratio 1990-2002
Non Financial Services
Insurers
Other Financial Services
Depository Institutions
Securities/Brokerage
44
Most Wealth Was Created in Last 200 YearsCan we
continue this trend for another 200 years?
45
Financial Innovation Last Thousand Year
1633 Promissory notes 1640 Short sale for cash
flow financing.
1868 Chicago board of trade Mutual Fund Started
3000 - 2000 BC Development of Banking in
Mesopotamia
1829 Deposit Insurance
1494 Double entry book keeping 1498 Capital
and foreign exchange markets
1156Foreign exchange contract 1160 Bill of
Credit
1723 Notes secured by Mortgage
1751 Consols 1770 Clearing House 1772 Branch
Banking 1775 Savings and Loans
806 Paper money
1609 The central bank founded
1200Contracts promising future delivery
(derivatives)
1401 Bank of Barcelona founded
1881 Post office notes
1681 First public note-issuing bank founded
1920 Payment card
46
Financial Innovation Last 50 Years
47
1960s to 1980s Financial Innovation

• Can any twenty-year period in recorded history
  have witnessed even a tenth as much financial
  innovation?
• Merton Miller

48
Financial Innovations Reduce Volatility
Selected Macroeconomic Volatility Before and
After FI Period
Source Jermann and Quadrini 2006
49
Wealth Creation in the U.S. since World War II

• 1945-70 Manufacturing
• 1970s Inflation
• 1980s Asset, liability mgmt., derivatives,
  commoditization of mortgages and bank debt (Junk
  Bonds)
• 1990s High tech, Telecom
• 2000s Commoditization of air and water

50
The Commoditization of Air Water

• Clean Air Act Amendments of 1990 - SO2 emission
  allowance trading
• Kyoto Protocol of 1997 - Greenhouse gas (GHG)
  emission trading
• Launch of the Chicago Climate Exchange, 2003
• Launch of the Chicago Climate Futures Exchange,
  2004
• Water markets in the Southwest and the Great
  Lakes

51
Why Carbon Emissions Trading?

• Proven, least-cost, and comprehensive tool for
  managing emissions (CCX as an Emissions
  Management System)
• Environmental stewardship that rewards
  environmental innovation and strategic planning
• Flexibility, market efficiencies
• Multiple successes US SO2, lead phase-out
  (gasoline), NOx, ETS
• Enhances coherent management practices and
  technological innovation
• Establish value to scare resource
• Carbon price signal
• Reveals hidden assets and hidden costs throughout
  operations

52
Role of Price Discovery

• To stimulate inventive activity
• To reorganize corporate financial decision-making
• To monetize hidden assets

53
Environmental Markets on the Horizon

• Water
• Western United States
• Snowpack could be reduced by 25 by 2050 in
  California due to climate change
• Colorado River delivery system fully allocated
  and on the brink of failure
• Runoff declining while demand is increasing
• Water already extensively litigated with more to
  come
• Northern China
• Has been warned of a water crisis by 2030 when
  per capita consumption is expected to fall below
  the internationally recognized standard for
  shortage
• Rivers are heavily polluted
• Agriculture impossible in certain regions

54
Environmental Markets on the Horizon

• Water
• Middle East
• Water scarcity a significant political issue
• Need to develop peaceful, sustainable solutions
  between Jordan, Syria, Israel, Palestine, other
  countries
• Great need for a comprehensive water plan for the
  countries to share the resource
• Africa
• Climate change anticipated to reduce
  precipitation in regions near the equator
• Water quality problems lead to millions of deaths
  by infants every year
• Non GHG Pollutants
• Wildlife and Endangered Species

55
Diffusion of financial innovation
56
Seven Stages of Market Evolution

• 1. Structural change - demand for capital
• 2. Uniform commodity/security standards
• 3. Legal instrument providing evidence of
  ownership
• 4. Informal spot and forward markets
• 5. Emergence of exchanges
• 6. Organized futures and options markets
• 7. Proliferation of OTC markets, deconstruction