The Best Derivative Ever - Chatham Financial

What if we told you that there was a derivatives contract so perfect in concept and execution that the non-financial counterparty had huge potential upside without any downside risk? What if we further told you that everyone – all parties to the derivative, related institutions, and society as a whole – could be made holistically better off from the transaction? Wouldn’t that be the best derivative ever, worthy of special acclaim on World Derivatives Day?

“Come, come,” you might say, “that’s too good to be true. This World Derivatives Day spirit has gone to your head, and you’ve forgotten core principles of economics like greed, moral hazard, and zero sum games. No derivative could benefit all stakeholders this way … right?”

Let us begin by telling you about juvenile recidivism rates in Massachusetts. Every year in the Commonwealth, 4000 high-risk young men leave prison or probation, but within three years 55% are incarcerated again, often for violent offenses. For more than 25 years, a non-profit organization called Roca has been active in places like Chelsea, Revere, East Boston, and Springfield, using purposeful intervention and practical job training to break this cycle. According to a Harvard study, the approach is working – only 37% of Roca’s clients return to incarceration within three years, with many finding stable employment instead. Due to funding constraints, however, Roca has not been able to expand its impact to serve more high-risk juveniles.

Enter the Massachusetts Juvenile Justice Pay for Success Initiative, aka the Best Derivative Ever. Here’s a quick rundown on all things this panacean derivative accomplishes:

Increasing footprint: A total of $27 million has been raised from philanthropic organizations and private lenders to expand Roca’s footprint in the at-risk-for-incarceration population. This means that around 929 young men will have access to focused intervention specifically designed to prevent recidivism and increase employment.

Less crime: Roca was chosen to participate in the Pay for Success Initiative after a competitive process, because it demonstrably reduces incarceration rates and promotes job acquisition and retention in its clients. Its historical success was established based on a study of Roca’s records conducted by the Harvard Kennedy School’s Social Impact Bond Lab, compared against a control population without intervention.

No downside / big upside: One of the exciting parts about this derivative is that the Commonwealth of Massachusetts pays nothing for it. Yes, you read that right, nothing! If the program is unsuccessful in reducing incarceration, the state doesn’t have to pay lenders one cent. If the program materially reduces incarceration and increases employment, the state makes success payments which are always smaller than the savings achieved from having a smaller prison population and a higher productively employed population. If the young men Roca serves spend 70% fewer days in jail compared to their peers, then due to reduced incarceration costs Massachusetts will net $18 million in savings after all obligations under the derivative!

Aligned incentives: The last few years have seen numerous publicized examples of parties to large derivative contracts front-running the market to benefit themselves at the expense of their counterparties. But in this derivative, incentives are fantastically aligned – if the lenders to the program were to intervene surreptitiously in Massachusetts to prevent crime and create jobs, thereby increasing their payout, then Massachusetts taxpayers would also save money, while at-risk young men would spend less time in prison for violent crime and more time at work. Win-win-win!

Governmental accountability: When spending programs get inserted into a government budget, they are notoriously difficult to remove when shown to be ineffective, if they are ever tested for effectiveness at all. This Pay for Success Initiative requires success in reducing incarceration and increasing employment, or it doesn’t pay out anything at all. Just imagine if every government initiative targeting societal impact had to establish metrics and prove the success of its methods prior to getting any taxpayer money! We can almost hear “What a Wonderful World” playing in the background.

Program replicability: The participants in the Massachusetts Juvenile Justice Pay for Success Initiative hope that it can be a proof of concept for future transactions, increasing the flow of philanthropic and private capital to education, employment, social service, and public health sectors. If new sources of funding can be matched with community initiatives that measure and hold themselves accountable for results, only receiving payment upon success, the very nature of investment in human potential could be transformed.

We hope that this heart-warming true story of a win-win-win derivative brightens your spirits on this World Derivatives Day, and that you are able to celebrate this special holiday with those you love. While some have maligned derivatives as weapons of mass destruction, we like to view them (in the right hands) as instruments of societal reconstruction. Happy World Derivatives Day, and best wishes for a year filled with highly effective risk management from all of us at Chatham. Give us a call at 610.925.3120 or tweet us at @ChathamFin with the hashtag #ChathamWDD