Posts Tagged ‘regulation’
“The pursuit of science is a grand adventure, driven by curiosity, fueled by passion, and guided by reason”*…
Adam Mastroianni on how science advances (and how it’s held back), with a provocative set of suggestions for how it might be accelerated…
There are two kinds of problems in the world: strong-link problems and weak-link problems.
Weak-link problems are problems where the overall quality depends on how good the worst stuff is. You fix weak-link problems by making the weakest links stronger, or by eliminating them entirely.
Food safety, for example, is a weak-link problem. You don’t want to eat anything that will kill you. That’s why it makes sense for the Food and Drug Administration to inspect processing plants, to set standards, and to ban dangerous foods…
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Weak-link problems are everywhere. A car engine is a weak-link problem: it doesn’t matter how great your spark plugs are if your transmission is busted. Nuclear proliferation is a weak-link problem: it would be great if, say, France locked up their nukes even tighter, but the real danger is some rogue nation blowing up the world. Putting on too-tight pants is a weak-link problem: they’re gonna split at the seams.
It’s easy to assume that all problems are like this, but they’re not. Some problems are strong-link problems: overall quality depends on how good the best stuff is, and the bad stuff barely matters. Like music, for instance. You listen to the stuff you like the most and ignore the rest. When your favorite band releases a new album, you go “yippee!” When a band you’ve never heard of and wouldn’t like anyway releases a new album, you go…nothing at all, you don’t even know it’s happened. At worst, bad music makes it a little harder for you to find good music, or it annoys you by being played on the radio in the grocery store while you’re trying to buy your beetle-free asparagus…
Strong-link problems are everywhere; they’re just harder to spot. Winning the Olympics is a strong-link problem: all that matters is how good your country’s best athletes are. Friendships are a strong-link problem: you wouldn’t trade your ride-or-dies for better acquaintances. Venture capital is a strong-link problem: it’s fine to invest in a bunch of startups that go bust as long as one of them goes to a billion…
In the long run, the best stuff is basically all that matters, and the bad stuff doesn’t matter at all. The history of science is littered with the skulls of dead theories. No more phlogiston nor phlegm, no more luminiferous ether, no more geocentrism, no more measuring someone’s character by the bumps on their head, no more barnacles magically turning into geese, no more invisible rays shooting out of people’s eyes, no more plum pudding…
Our current scientific beliefs are not a random mix of the dumbest and smartest ideas from all of human history, and that’s because the smarter ideas stuck around while the dumber ones kind of went nowhere, on average—the hallmark of a strong-link problem. That doesn’t mean better ideas win immediately. Worse ideas can soak up resources and waste our time, and frauds can mislead us temporarily. It can take longer than a human lifetime to figure out which ideas are better, and sometimes progress only happens when old scientists die. But when a theory does a better job of explaining the world, it tends to stick around.
(Science being a strong-link problem doesn’t mean that science is currently strong. I think we’re still living in the Dark Ages, just less dark than before.)
Here’s the crazy thing: most people treat science like it’s a weak-link problem.
Peer reviewing publications and grant proposals, for example, is a massive weak-link intervention. We spend ~15,000 collective years of effort every year trying to prevent bad research from being published. We force scientists to spend huge chunks of time filling out grant applications—most of which will be unsuccessful—because we want to make sure we aren’t wasting our money…
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I think there are two reasons why scientists act like science is a weak-link problem.
The first reason is fear. Competition for academic jobs, grants, and space in prestigious journals is more cutthroat than ever. When a single member of a grant panel, hiring committee, or editorial board can tank your career, you better stick to low-risk ideas. That’s fine when we’re trying to keep beetles out of asparagus, but it’s not fine when we’re trying to discover fundamental truths about the world…
The second reason is status. I’ve talked to a lot of folks since I published The rise and fall of peer review and got a lot of comments, and I’ve realized that when scientists tell me, “We need to prevent bad research from being published!” they often mean, “We need to prevent people from gaining academic status that they don’t deserve!” That is, to them, the problem with bad research isn’t really that it distorts the scientific record. The problem with bad research is that it’s cheating.
I get that. It’s maddening to watch someone get ahead using shady tactics, and it might seem like the solution is to tighten the rules so we catch more of the cheaters. But that’s weak-link thinking. The real solution is to care less about the hierarchy…
Here’s our reward for a generation of weak-link thinking.
The US government spends ~10x more on science today than it did in 1956, adjusted for inflation. We’ve got loads more scientists, and they publish way more papers. And yet science is less disruptive than ever, scientific productivity has been falling for decades, and scientists rate the discoveries of decades ago as worthier than the discoveries of today. (Reminder, if you want to blame this on ideas getting harder to find, I will fight you.)…
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Whether we realize it or not, we’re always making calls like this. Whenever we demand certificates, credentials, inspections, professionalism, standards, and regulations, we are saying: “this is a weak-link problem; we must prevent the bad!”
Whenever we demand laissez-faire, the cutting of red tape, the letting of a thousand flowers bloom, we are saying: “this is a strong-link problem; we must promote the good!”
When we get this right, we fill the world with good things and rid the world of bad things. When we don’t, we end up stunting science for a generation. Or we end up eating a lot of asparagus beetles…
“Science is a strong-link problem,” from @a_m_mastroianni in @science_seeds.
* James Clerk Maxwell
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As we ponder the process of progress, we might spare a thought for Sir Christopher Wren; he died on this date in 1723. A mathematician and astronomer (who co-founded and later served as president of the Royal Society), he is better remembered as one of the most highly acclaimed English architects in history; he was given responsibility for rebuilding 52 churches in the City of London after the Great Fire in 1666, including what is regarded as his masterpiece, St. Paul’s Cathedral, on Ludgate Hill.
Wren, whose scientific work ranged broadly– e.g., he invented a “weather clock” similar to a modern barometer, new engraving methods, and helped develop a blood transfusion technique– was admired by Isaac Newton, as Newton noted in the Principia.
“Success is in making money, not in the size of the airline”*…
Airlines make more money from mileage programs than from flying planes—and it shows. Ganesh Sitaraman explains…
… From the late 1930s through the ’70s, the federal government regulated airlines as a public utility. The Civil Aeronautics Board decided which airlines could fly what routes and how much they could charge. It aimed to set prices that were fair for travelers and that would provide airlines with a modest profit. Then, in 1978, Congress passed a sweeping law deregulating the airline industry and ultimately abolishing the CAB. Unleashed from regulation, airlines devised new tactics to capture the market. American Airlines was one of the most aggressive. In the lead-up to the deregulation bills, it created discount “super saver” fares to sell off the final few remaining seats on planes. That meant cheap prices for last-minute travelers and more revenue for American, because the planes were going to take off whether or not the seat was filled. But these fares upset business travelers, who tended to buy tickets further in advance for higher prices. So in 1981, American developed AAdvantage, its frequent-flier program, to give them additional benefits. Other airlines followed suit.
In the early years, these programs were simple, like the punch card at a café where your 11th coffee is free. But three big changes transformed them into the systems we know today. First, in 1987, American partnered with Citibank to offer a branded credit card that offered points redeemable for flights on the airline. Second, in the ’90s, the airlines proliferated the number of fare classes, charging differential prices for tickets. With more complicated fare structures came the third change: Virgin America realized that the amount people spend on a flight, based on the fare class, is more important to their bottom line than the number of miles flown. So, in 2007, it introduced a loyalty program rewarding money spent rather than mileage accrued.
These three shifts fundamentally transformed the airline industry. They turned frequent-flier systems into the sprawling points systems they are today. And they turned airlines into something more like financial institutions that happen to fly planes on the side.
Here’s how the system works now: Airlines create points out of nothing and sell them for real money to banks with co-branded credit cards. The banks award points to cardholders for spending, and both the banks and credit-card companies make money off the swipe fees from the use of the card. Cardholders can redeem points for flights, as well as other goods and services sold through the airlines’ proprietary e-commerce portals.
For the airlines, this is a great deal. They incur no costs from points until they are redeemed—or ever, if the points are forgotten. This setup has made loyalty programs highly lucrative. Consumers now charge nearly 1 percent of U.S. GDP to Delta’s American Express credit cards alone. A 2020 analysis by the Financial Times found that Wall Street lenders valued the major airlines’ mileage programs more highly than the airlines themselves. United’s MileagePlus program, for example, was valued at $22 billion, while the company’s market cap at the time was only $10.6 billion.
Is this a good deal for the American consumer? That’s a trickier question. Paying for a flight or a hotel room with points may feel like a free bonus, but because credit-card-swipe fees increase prices across the economy—Visa or Mastercard takes a cut of every sale—redeeming points is more like getting a little kickback. Certainly the system is bad for Americans who don’t have points-earning cards. They pay higher prices on ordinary goods and services but don’t get the points, effectively subsidizing the perks of card users, who tend to be wealthier already.
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The strange evolution of airlines into quasi-banks reflects how badly deregulation has gone. Regulation carefully set the terms under which airlines could do business. It was designed to ensure that they remained a stable business and a reliable mode of transportation. Deregulation, in turn, allowed the airlines to pursue profits in whatever way they could—including getting into the financial sector.
The proponents of deregulation made a few big promises. The cost of flying would go down once airlines were free to compete on price. The industry would get less monopolistic as hundreds of new players entered the market, and it would be stable even without the government guaranteeing profitable rates. Small cities wouldn’t lose service. In the deregulators’ minds, airlines were like any other business. If they were allowed to compete freely, the magic of the market would make everything better. Whatever was good for the airlines’ bottom line would be good for consumers.
They were wrong. As I explain in my forthcoming book, most of their predictions didn’t come true, because air travel isn’t a normal business. There are barriers to entry, such as the fixed supply of airport runways and gates. (And, for that matter, mileage programs, designed to keep customers from ditching an established airline for a rival.) There are network effects and economies of scale. There are high capital costs. (Airplanes aren’t cheap.) The idea that anyone could successfully start an airline and outcompete the big incumbents never made much sense.
After a relatively short period of fierce competition, the deregulated era quickly turned to consolidation and cost-cutting, as dozens of airlines either went bankrupt or were acquired. Service keeps getting worse, because the airlines, facing little competition, have nothing to fear from antagonizing passengers with cramped legroom, cancellations, and ever-multiplying fees for baggage and snacks. Worse still, without mandated service, cities and regions across the country have lost commercial air service, with serious consequences for their economies. And when a crisis like 9/11 or the coronavirus pandemic comes along, the airlines—which prefer to direct their profits to stock buybacks rather than rainy-day funds—need massive financial relief from the federal government.
Deregulation even failed to deliver the one thing it is sometimes credited with: lowering prices. Airfare did get cheaper in the years after the 1978 deregulation law. But the cost of flying had already been falling before deregulation, and it kept falling after at about the same rate.
The old system of airline regulation wasn’t perfect. Barred from competing directly on price, the airlines got into an amenities arms race that notoriously included in-flight piano bars. But the cure was worse than the disease. The industry went from being a regulated oligopoly, which had real problems, to an unregulated oligopoly, which we are now seeing is much worse…
Painful reading: “Airlines Are Just Banks Now” (gift article) from @GaneshSitaraman in @TheAtlantic.
* Gordon Bethune (Long-time chair of Continental Airlines)
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As we pray for an aisle seat, we might console ourselves that at least we’re not boarding the S.S. Minnow; on this date in 1964 Gilligan’s Island premiered on CBS. Seven castaways– five paying passengers who’d booked a “three hour tour” from Honolulu, and their two-person crew– spent the next three seasons marooned on an uncharted island.
“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)
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