Posts Tagged ‘regulation’
“It’s very easy for trusted companies to mislead naive customers, and life insurance companies are trusted”*…
Systemic risk in the financial system– the kind that can create devastation like the Crash of 2008— has been the province of regulators for many decades, primarily the SEC and the Federal Reserve. But as our financial system has become more complex and intertwined, that risk may have moved from the stock market and banks to other sectors, sectors less well regulated. As John Ellis explains in his terrific newsletter, News Items, we might do well to turn our attention to the seemingly staid insurance industry…
The Fed exists to oversee banking, but lately it’s been keeping an eye on life insurance, too. Its recent Financial Stability Report flagged some life-insurance practices that might make the system vulnerable. Some insurers invest in assets that “can suffer sudden increases in default risk,” the report said. And some use “nontraditional” funding sources that could dry up “on short notice.”
That sounds ominous. But not long after that, Jon Gray, the president of private-equity giant Blackstone, turned up in a Financial Times article, saying life insurers had the wherewithal to bolster America’s weakened regional banks.
Gray said private equity firms like Blackstone could get “very low-cost capital” from life insurers and extend it to regional banks, to fund their lending operations. That would be a boon, because the banks’ usual source of funding, customer deposits, has grown more expensive and flighty in the wake of this year’s bank failures. So the life insurers could help ease a credit squeeze.
And once the banks make the loans, Gray said, the insurers might like to acquire some of them as investments. Blackstone manages billions of dollars of insurance investments, and Gray said the firm was already talking with large, unnamed regional banks about such deals.
So, what’s up with life insurance? Is the industry so flush it can send money to shore up America’s weakened banks? If so, then what’s the Fed worried about?
As it happens, a group of Fed economists has some answers. They got under the hood of the life insurance industry and combed through the voluminous regulatory filings of more than a thousand life insurers in the years since the crash of 2008. The U.S. financial system was going through major changes then, and they wanted to understand how the insurers had navigated the changing landscape.
One trend they observed: First, America’s bailed-out banks, seen as having gambled with their depositors’ money, were brought under the broad financial-reform legislation known as Dodd-Frank. It steered them away from making any more loans to big, low-rated borrowers. Then, once the banks had departed that space, life insurers moved in.
As a result, “These insurers have become exponentially more vulnerable to an aggregate corporate sector shock,” wrote the three economists, Nathan Foley-Fisher, Nathan Heinrich, and Stéphane Verani, in a paper first published in February 2020 and updated in April of this year.
Their findings cast the life insurance industry in a very different light from the traditional image of dull, stable companies plodding along under the weight of big, safe, bond-laden investment portfolios.
“Within ten years, the U.S. life insurance industry has grown into one of the largest private debt investors in the world,” the three wrote.
At the end of 2020, life insurers managed one-fourth of all outstanding CLOs, or collateralized loan obligations – bond-like securities backed by pools of loans to large, low-rated borrowers. Because the underlying borrowers have low ratings, CLOs pay a higher yield than the high-grade corporate bonds a conventional life portfolio would hold.
The insurers were also using unusual sources of capital to fuel their growth (funding-agreement-backed repos, anyone?). Not all life insurers, but a certain cohort was doing the kind of business the big banks did before the financial crisis, “but without the corresponding regulation and supervision.”
The economists called it “a new shadow-banking business model that resembles investment banking in the run-up to the 2007-09 financial crisis.”
Their reports describe the trends in detail, but in measured tones. No flashing red lights or alarm bells. But they do tell how things could go south: “A widespread default of risky corporate loans could force life insurers to assume balance sheet losses” from their CLO holdings.
Institutional investors watch life insurers carefully and know where the shadow-banking activity is concentrated; they would presumably see the losses coming and withdraw from the affected insurers in time. That’s what we’ve been seeing in the regional banking sector this spring, where savvy investors have identified potential problem banks and sold or shorted their stocks. The trouble is, such trading can turn a potential problem into a real one.
Upshot: “U.S. life insurers may require government support to prevent shocks from being amplified and transmitted to the household sector,” the three warn…
[Ellis explains how this happened; TLDR: life insurers chased yield; private equity firms obliged.]
The Fed researchers said the private-equity firms appear to be giving their affiliated insurers “some of the riskiest portions” of the CLOs that they package. Since risk and reward go hand in hand, presumably the insurers are getting better returns than they would from safe bonds.
But still, should America’s insurance regulators be allowing this? Remember, America’s banks were told to stop.
The National Association of Insurance Commissioners has, in fact, proposed a change in the post-crisis rule that’s been letting insurers count risky CLOs as if they were safe bonds.
But the NAIC isn’t a regulator; it’s a non-governmental organization that represents America’s 56 insurance regulators (one for each state, five for the territories, and one for the District of Columbia). The regulators often have different priorities and viewpoints, and when the NAIC makes a proposal, it can take years to get the necessary buy-in.
So here we are. Countless policyholders and annuitants are diligently paying their premiums to keep their contracts in force, unaware of these trends. The Fed’s economists see undisclosed risk, but the Fed has no legal authority to regulate insurers. The insurance regulators don’t seem in any rush to rein in the risk-takers. Keep in mind: Life-and-annuity is a $9 trillion industry that doesn’t have anything like the FDIC…
Eminently worth reading in full (along with the report and the paper linked above): “Risky Business,” from @EllisItems.
(Image above: source)
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As we whack the mole, we might recall that it was on this date in 1931 that the New York Stock Exchange began regularly reporting short selling data for the first time. The Crash of 1929 had rocked the stock market; the Dow dropped 32.6% in 1930 as the American economy took a nosedive (unemployment doubled to 16.3% by 1931, as the Great Depression set in). But short sellers in the stock market made a killing. Consequently, those short sellers took a lot of heat for the stock market crash of 1929, which led to the enactment of the uptick rule (requiring that short selling orders be filled only during upticks in share prices and meant to mitigate the negative impact of short sales) shortly thereafter. The reporting of short orders/sales was another step toward reining in the phenomenon.
The uptick rule was abolished in 2007, just prior to the market crash of 2008.
“When I read about the evils of drinking, I gave up reading”*…
As we’ve seen before, Prohibition spawned a number of creative work-arounds, some more legal than others. Most of them faded away with the 21st Amendment; but as Olivia White explains, one is still going strong…
Just off the coast of Winsconsin, in the frigid depths of Lake Michigan, sits Washington Island, a tiny island home to just over 700 people. Despite the small, three-digit population, Washington Island outsells every other town in the world when it comes to the amount of Angostura bitters consumed per capita. What could possibly be driving such impressive sales in such a small, remote place? Turns out the answer points back to one bar — Nelsen’s Hall — and it’s not because they’re dishing out thousands of Old Fashioneds.
Rather than garnering the title of largest Angostura purveyor by using the ingredient in an abundance of cocktails, Nelsen’s is famous for kick-starting the bizarre tradition of taking shots of Angostura. Not shots containing various spirits and a dash or two of Angostura, but 1.5-ounce servings of straight-up bitters.
First opened as a dance hall in 1899, Nelsen’s Hall was founded by Tom Nelsen, who expanded the space into a bar three years later. Less than two decades later, when Prohibition threatened the security of his bar, Nelsen was forced to get crafty in coming up with ways to remain open. Instead of operating with an alcohol license — which had for obvious reasons been stripped away — Nelsen acquired a pharmaceutical license as a sneaky way to legally sell the shots.
As Angostura bitters are only intended to be used a few drops at a time, at the time of Prohibition, they were classified as a “stomach tonic for medicinal purposes,” despite the fact that they contain 44.7 percent alcohol by volume. As such, Nelsen acquired a pharmaceutical license that allowed him to legally distribute Angostura as a medical tincture…
Today, the Angostura shot remains one of the most popular menu items at Nelsen’s Hall, which is known to go through three cases of bitters on busier weekends. Annually, the bar sells upwards of 10,000 Angostura shots; every person who chooses to partake earns a spot in the “Bitters Club” and receives a card certifying that they have “taken ‘the Cure’ by consuming the prescribed measure of bitters and as such [are] a fully initiated member of the Bitters Club.” Upon signing their own name in a decades-old book, shot-takers are “considered a full-fledged Islander and entitled to mingle, dance, etc. with all the other islanders.”
The vestigial remains of long-dead regulation: “Wisconsinites Drink an Ungodly Amount of Angostura — Blame It on a Prohibition Loophole,” from @VinePair.
* Henny Youngman
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As we contemplate unintended consequences, we might send dry birthday greetings to Alphonso Alvah Hopkins; he was born on this date in 1843. A teacher, author, journalist, editor, publisher, and politician, he is best remembered as one of the leading Temperance activists of his time. Hopkins ran as the Temperance Party’s candidate for New York State’s Secretary of State, member of Congress, and Governor; he published several books, including two temperance novels entitled His Prison Bars, and Sinner and Saint, and Wealth and Waste, a treatise which applies the principle of political economy to the problems of labor, law, and the liquor traffic; and throughout, he taught at the American Temperance University.
“The opposite of knowledge is not ignorance, but deceit and fraud”*…
In follow-on to our last look at corporate fraud, a provocative piece by Byrne Hobart…
This paper has been getting some attention lately for its eye-catching estimates: 11% of publicly traded companies are committing securities fraud every year, with an annual cost of over $700bn…
[There follows an illuminating discussion of lessons that can be drawn for the follow-on to Arthur Andersen’s collapse after the implosion of Enron, the rules/regulations developed then to prevent similar public company frauds, and a consideration of whether corporate fraud has waned– at least among publicly-traded companies– and is perhaps a little less wide-spread than the paper argues…]
But since fraud is a human problem, and not purely a matter of better accounting standards, it’s not likely to have just gone away. But if the rate of accounting problems among big publicly-traded companies is lower than the 11% number cited in the paper, the question isn’t “why did it disappear?” but rather “where did it go?” And we can take our list of trends against fraud and invert them:
• Sarbanes-Oxley does apply to private companies, but only on the penalty side, not the disclosure side. But accounting frauds in private companies are often less visible; many investments go to zero, anyway, and it’s less embarrassing for everyone involved not to say why.
• There are no short-sellers in private markets. There have been efforts here, but they don’t work out because the market doesn’t clear (“everyone wanted to short Theranos, Dropbox and WeWork”). The closest you can get to shorting is to pass on a round and then brag about it later. Big deal: I didn’t invest in FTX, either.
• There’s less data available on private companies, though the rise of alternative data tools means it’s easier to get decent proxies.
• Startups are not expected to return capital. It’s a bad sign if they do. They’re often valued either based on strategic considerations or starting with a multiple of sales—a dollar of sales is much easier to fake than a dollar of earnings or cash flow, so the incentive to do so is strong.
• The idea market in startups is liquid when it comes to successes, but it would be pretty tacky for a VC to write a long blog post explaining why they passed on a live deal. (That memo may exist internally, but to the extent that it’s shared it’s in the form of a quick summary over Twitter DM or Signal.)
JPMorgan Chase’s writedown of their fintech acquisition Frank is a great case study in all of these forces. The NYT has a good story digging into the details: Frank’s founder is a serial exaggerator whose self-promotion veered into fraud (once again, if the rate of continuous improvement in public perception to be maintained exceeds what the fundamentals can deliver, compound interest works its ruthless magic). The company was valued at a high multiple of what turned out to be a flexible metric, total email addresses captured. And there were alternative datasets that could have pointed to problems: given the likely number of student aid applicants in the US, Frank’s numbers implied that it had reached near-dominant market share in the category with little marketing. Meanwhile, its monthly site traffic was not enough to have acquired that sizable a customer list over Frank’s entire existence. So it could have been caught, if the buyer had been looking for fraud. But one paradox of frauds and cheats in general is that lying is less than half the work—most of the effort is in appearing not to need to lie. The more impressive a company looks, the more embarrassing the basic due diligence questions are.
A down market and a series of high-profile failures might give private markets the same kind of natural experiment that Arthur Andersen’s failure did for public markets. Due diligence checklists will get longer and more thorough, and new funding rounds will feel more like a cross-examination and less like a party. One reason for a high base rate of fraud is that at least some of it stems from inattention rather than malice—the Arthur Andersen study finds that most of the frauds were fairly minor, and could be more the result of poor internal metrics than of intent to mislead. But either way, standards will get higher, and private companies will need to step up their efforts accordingly…
Has the primary locus of corporate fraud moved from public to private companies? “Where Fraud Lives and Why,” from @ByrneHobart.
[Image above: source]
* Jean Baudrillard
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As we do due diligence, we might recall that it was on this date in 2016 that the Centers for Medicare and Medicaid Services (CMS) sent a letter to Theranos after an inspection of its Newark, California, lab. The investigation, which took place in the fall of 2015, had found that the facility did not “comply with certificate requirements and performance standards” and caused “immediate jeopardy to patient health and safety.” This followed on three exposes on Theranos in the Wall Street Journal (in October [here and here] and December of 2015) and a critical FDA report. Things unraveled from there: in March, 2018, Thearnos, CEO Elizabeth Holmes, and President Sunny Balwani were charged by the FCC with fraud. Three month later, a federal grand jury indicted both Holmes and Balwani on two counts of conspiracy and nine counts of wire fraud, finding that the pair had “engaged in a multi-million dollar scheme to defraud investors, and a separate scheme to defraud doctors and patients.” Theranos closed in 2018. Holmes was convicted and sentenced to 11 years in prison for her crimes (a sentence she is appealing); Balwani, to 13 years.
Theranos was a private company, funded by investors including Henry Kissinger, Betsy DeVos, Carlos Slim, and Rupert Murdoch.
Elizabeth Holmes found guilty (source)
“It’s going to be interesting to see how society deals with artificial intelligence”*…
Interesting, yes… and important. Stephanie Losi notes that “in some other fields, insufficient regulation and lax controls can lead to bad outcomes, but it can take years. With AI, insufficient regulation and lax controls could lead to bad outcomes extremely rapidly.” She offers a framework for thinking about the kinds of regulation we might need…
Recent advances in machine learning like DALL-E 2 and Stable Diffusion show the strengths of artificial narrow intelligence. That means they perform specialized tasks instead of general, wide-ranging ones. Artificial narrow intelligence is often regarded as safer than a hypothetical artificial general intelligence (AGI), which could challenge or surpass human intelligence.
But even within their narrow domains, DALL-E, Stable Diffusion, and similar models are already raising questions like, “What is real art?” And large language models like GPT-3 and CoPilot dangle the promise of intuitive software development sans the detailed syntax knowledge required for traditional programming. Disruption looms large—and imminent.
One of the challenges of risk management is that technology innovation tends to outpace it. It’s less fun to structure a control framework than it is to walk on fresh snow, so breakthroughs happen and then risk management catches up. But with AI, preventive controls are especially important, because AI is so fast that detective and corrective controls might not have time to take effect. So, making sure controls do keep up with innovation might not be fun or flashy, but it’s vital. Regulation done right could increase the chance that the first (and possibly last) AGI created is not hostile as we would define that term.
In broad strokes, here are some aspects of a control framework for AI…
Eminently worth reading in full: “Possible Paths for AI Regulation.”
See also: “Can regulators keep up with AI in healthcare?” (source of the image above)
And as we ponder constructive constraints, we might keep in mind Gray Scott‘s (seemingly-contradictory) reminder: “The real question is, when will we draft an artificial intelligence bill of rights? What will that consist of? And who will get to decide that?”
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As we practice prudence, we might recall that it was on this date in 1971 that UNIX was released to the world. A multi-tasking, multi-user operating system, it was intitally developed at ATT for use within the Bell System. Unix systems are characterized by a modular design that is sometimes called the “Unix philosophy.” Early Unix developers were important in bringing the concepts of modularity and reusability into software engineering practice, spawning a “software tools” movement. Over time, the leading developers of Unix (and programs that ran on it) established a set of cultural norms for developing software, norms which became as important and influential as the technology of Unix itself– a key part of the Unix philosophy.
Unix’s interactivity made it a perfect medium for TCP/IP networking protocols were quickly implemented on the Unix versions widely used on relatively inexpensive computers, which contributed to the Internet explosion of worldwide real-time connectivity. Indeed, Unix was the medium for Arpanet, the forerunner of the internet-as we-know-it.
Ken Thompson (sitting) and Dennis Ritchie, principal developers of Unix, working together at a PDP-11 (source)
“Virtue is more to be feared than vice, because its excesses are not subject to the regulation of conscience”*…
Regulation often addresses real public needs/concerns. But the costs of compliance often favor the largest players in a regulated market– which can lead to consolidation. From the Oxford Martin School, a current example…
Exploiting the timing and territorial scope of the European Union’s General Data Protection Regulation (GDPR), this paper examines how privacy regulation shaped firm performance in a large sample of companies across 61 countries and 34 industries. Controlling for firm and country-industry-year unobserved characteristics, we compare the outcomes of firms at different levels of exposure to EU markets, before and after the enforcement of the GDPR in 2018. We find that enhanced data protection had the unintended consequence of reducing the financial performance of companies targeting European consumers. Across our full sample, firms exposed to the regulation experienced a 8% decline in profits, and a 2% reduction in sales. An exception is large technology companies, which were relatively unaffected by the regulation on both performance measures. Meanwhile, we find the negative impact on profits among small technology companies to be almost double the average effect across our full sample. Following several robustness tests and placebo regressions, we conclude that the GDPR has had significant negative impacts on firm performance in general, and on small companies in particular…
“Privacy Regulation and Firm Performance: Estimating the GDPR Effect Globally,” from @oxmartinschool via @benedictevans
[Image above: source]
* Adam Smith
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As we seek balance, we might recall that it was on this date in 1969 that the U.S. officially withdrew $500, $1,000, $5,000, and $10,000 bills from circulation, pursuant to an executive order by President Richard Nixon. The larger bills had been used by banks and the government for large financial transactions, but had been rendered obsolete by the electronic money transfer system.
Those large-denomination bills were last printed on December 27, 1945 and are still considered legal tender. Indeed, (a version of) the $500 is still used in the game of Monopoly.
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