Risks From Yesteryear
What The Billion Dollar Bubble can teach us about risk: Solar Insurance Winds; Money Laundering; Buffett’s Pharma Bet; Crypto IPO
When conscience is immobilised, public trust has disappeared.
— Ray Dirks
Risk Developments this letter:
Solar Insurance Winds
Money Laundering
Buffett’s Pharma Bet
Crypto IPO
Digital Bubble
Equity Funding Corporation of America (EFCA), the first great fraud of the 21st century, was a mutual fund and life insurance conglomerate that blew up in 1973. I say it was a 21st century fraud because it was a scheme that was ahead of its time. Unlike the fairly plebeian frauds of Bernie Madoff or Theranos, which actually took place in after the millennium, EFCA exploited the gap between those with technical knowledge and those without to lie about sales and revenue.
I discovered this story, via actuary and writer Mary Pat Campbell, through the terrific made for TV movie, Billion Dollar Bubble. At first it seemed so patently unbelievable that I didn’t know it was non-fiction. The movie outlines how executives and IT employees conspired to forge insurance policies using a new computer system. For years the fraudsters were able to illude auditors, regulators and investors by selling fake policies off to reinsurers to create cashflow that they could use to pay premiums on the fake policies they had already sold.
What is significant about this scam is that computerized fraud has three advantages. First, while all accounting is fiction, digital accounting adds another layer of abstraction. Second, the programmatic creation of forged insurance policies allowed it to scale rapidly, which kept the pyramid scheme going longer. Third, digitization centralized control such that a few insiders could perpetrate the fraud. The three benefits of computers, abstraction, scale and central control are also major risks. It is only when the fraudsters had to start manually filing paperwork, forging addresses and providing (fake) interviews, that the system came crashing down.
The ensuing trial uncovered a shocking lack of due diligence (and possibly willful collaboration) on the part of reinsurers, auditors and investors. This reminds me of a point made by Slavoj Žižek:
Already in Stalinism, it was not only prohibited to criticise Stalin and the party publicly, it was even more prohibited to announce this prohibition publicly. If someone were to shout back at a critic of Stalin, “Are you crazy? Don’t you know that we are not allowed to do this?” he would have disappeared into the Gulag even faster than the open critic of Stalin.
Risk Developments
Solar Insurance Winds
2020 was a tough year for cyber insurance as numerous attacks increased claims, driving up premiums in turn. Risk pooling works best when perception of risk is high, but frequency is relatively low. Perceptions and frequencies have blown cyber insurers off course in the past and part of what underwriters do is tack to get back on course, but the SolarWinds breaches raises a question about the degree to which cyber is an insurable peril without government support.
Insurable risks have infrequent, uncorrelated, and relatively low impact losses, even if they are not entirely foreseeable. Government is in a difficult position with cyber losses because the private sector has externalized the losses of a (confidentiality) breach, but internalizing them through harsher penalties may make the risks uninsurable. The danger here is that abstraction creates an arbitrage opportunity that insurers can take advantage of without providing much remuneration.
Money Laundering
Credit Suisse is in hot water again for failing to comply with Swiss anti-money laundering (AML) laws in a case from the 2000’s where a Bulgarain wrestler laundered drug profits through the bank. French bank, Societe Generale was also recently on the hook for AML infractions. Pushing against institutional incentives is always going to be difficult for regulators, and as AML requirements mount, it gets harder and harder for small banks to compete with the high fixed costs of AML theater.
In America, where the banking sector has traditionally been much more fragmented, the OCC is mulling over letting some smaller banks and credit unions skip money laundering reports. This could push illegal activity towards these banks. In a world where the incentives seem stacked against you, maybe the best equilibrium one can hope for is fraud that doesn’t scale.
Buffett’s Pharma Bet
Last month Warren Buffett’s Berkshire Hathaway made a few big bets on pharmaceutical companies. In mid November, it might have looked like he was trying to pick vaccine winners, and sure enough, he did buy plenty of Pfizer only weeks before their announcement, but the other three stakes, Abbvie Inc, Bristol-Myers Squibb Co, Merck & Co, were each ten times as big as his Pfizer bet. In hindsight, this looks like a small bet on a short term win for Pfizer and a big bet that the Biden administration would be a lot friendlier to pharma.
Crypto IPO
Coinbase announced it’s IPO back in mid December, and just a day later named Goldman Sachs as the lead bank. Matt Levine had a shtick where he joked about all the crazy antics bankers would do to win a deal, like driving for Uber or cooking a Blue Apron meal. Goldman has been kind of a crypto leader among investment banks, so this kind of makes sense, but wouldn’t it be even better if Goldman revealed they had a secret bitcoin mining operation complete with crazy spokesman? Man I hope some competitor bank CEO goes full HODL to try to win a piece of the deal.
Gratitude
Thank you to everyone who joined me on this journey this year! It’s really amazing to go from just a couple dozen readers to hundreds and I hope to continue to hear from you. Also, big thanks to Mary Pat Campbell for suggesting Billion Dollar Bubble and Matt Levine for providing financial education and entertainment throughout the years. Lastly, Happy New Year and hope you all have a great 2021!