The Story Range
What we can learn from War and Peace and a napkin about risk.
Two short programming notes before we dive in:
- Welcome new readers! Readership is up 100% since the last newsletter, thanks mostly to the kind words of Byrne Hobart at The Diff.
- I have been accepted to the On Deck Writers Fellowship! Please help me hone my voice and improve my writing by providing feedback here or on Twitter.
“The ancients left us examples of heroic poems in which heroes constitute the entire interest of history, and we still cannot get used to the fact that, for our human time, history of this sort has no meaning.” - Leo Tolstoy, War and Peace
Risk Developments this letter:
The Home-front
Insurance Issues
FinTech & GovSec
Know Thyself
Microsoft Moves
Cyberspace to Aerospace
Spectrum
Power, Petroleum and Processors
Napkin Sketch, Arthur Laffer
War and Peace and a Napkin
In 1974 a young Donald Rumsfeld and Dick Cheney sat with an economist and a journalist at The Two Continents restaurant in the Hotel Washington. They were meeting to cook up a new kind of economic plan for the struggling Ford administration. The economist, Arthur Laffer, was so struck with the idea of diminishing returns on taxation, that he began to mark up the only thing he could find to write on, a napkin. The policy implications would not reappear until that same journalist, turned political advisor, would share this story in his influential book, The Way The World Works. What fascinates me, is not the supply-side fashion he started in policy circles, or the much criticized and oversimplified theory that cutting taxes could increase government revenues, but the fundamental truth about the right amount of story.
The math behind the tax theory, that given a quadratic there is a point of diminishing returns, is pretty dry as far as political rallying cries go. So how did this napkin meme go from wonk chatter in 1974 to Reagan saying, “Whenever we lower the tax rates, our entire nation is better off” in 1984? That’s the power of a good story. Just read my friend Leon’s recent post on stories at his newsletter “Avoid Boring People” that helped to inspire the theme of this newsletter.
A good story is exciting, but familiar. That napkin sketch feels familiar because it is used all the time. What makes it exciting is novelty. Combine familiarity and novelty and you have the beginnings of a good story. Combine a few good stories and you have the basis for a pitch, or a philosophy or a great novel. Leo Tolstoy’s War and Peace does just that. He set out to write a simple work of historical fiction but ended up delivering a treatise on the Russian soul.
Tolstoy described War and Peace as, “not a novel, even less is it a poem, and still less a historical chronicle.” What does this have to do with Laffer’s napkin? War and Peace is not just a story. It’s not even many stories. It’s a story about stories. After weaving together royal court drama, a personal love story, and the epic events that span Napoleon’s fall, Tolstoy wanders into in philosophy and criticism of the Great Man Theory of history. Tolstoy rejects the two popular modalities of the day, French — romantic and individualistic, and Prussian — rational and bureaucratic and instead finds a third way. We have spoken about realism, liberalism, and constructivism here before. In War and Peace, Tolstoy demonstrates how great events in history unfold as the sum of many petty and personal decisions. Realist heros are brittle and Liberal rules are inflexible. Constructivist stories are evergreen.
In other criticism of Great Man Theory, check out Alex Danco’s terrific post over at “Two Truths and a Take” about whether founders are allowed to lie (Thanks to Hollis Robbins for making the connection). Sometimes it can be difficult to differentiate a story from a fraud, since all frauds are stories, but not all stories are frauds. Below I’ve drawn a “Laffer Curve” for stories. Creating value requires some doing new things and new things are brought into the world by story. Most of life exists in the normal range, but frauds and fortunes exist in the story range.
Before getting to the risk developments over the last two weeks, I’d like to close with an ontology of frauds, as described by investor Geoff Lewis. Three basic types of frauds as outlined by Geoff:
Complex - Enron
Personal - Theranos
Dumb - Nikola
Not enough story is too rigid, too much story is a fraud. If our frauds are getting dumber, it’s because our stories are getting worse. Bad stories are either too familiar or too novel. A useful framework to keep in mind as you read the developments this letter.
Risk Developments this letter:
The Home-front
Insurance Issues
FinTech & GovSec
Know Thyself
Microsoft Moves
Spectrum
Power, Petroleum and Processors
A New Front
The Home-front
Two big changes to the home life have been working their way through the economic system this year. The first, work from home, and the second, driven by the first, home buying. Developers are glad to work from home and possibly even more productive without distractions and commuting. There are downsides, however, as tasks that require coordination and cooperation, such as security suffer.
Just how much work from home is a security threat is an unfolding story. A survey of American and European businesses found that the number of attacks is down this year, but the loss per attack is up. This is tough for cyber insurance in the short run, since current premiums are too low to offset sever losses, but good for cyber insurance in the long run. More on this story below in Insurance Issues.
On the home buying front, mortgages and mortgage backed securities are way up. The story here is that Covid-19 destroyed the benefits of density and just left the costs, driving people out of cities. A recent survey of new home owners contradicts that story saying a plurality of new home owners were opportunistically capitalizing on interest rates, and now have high levels of regret.
If the last housing lie was the complexity of Mortgage Backed Securities, and this one is a personal campaign to offset a weak labor market with cheap debt, the next one could look dumber than anything we’ve seen before.
Insurance Issues
On the heels of Duck Creek going public, private equity firm Thoma Bravo is taking Majesco, a Duck Creek competitor, private. Majesco has an interesting origin story, being spun out of a software outsourcing shop, and into the U.S. market through a series of acquisitions. One way to read this rivalry is a story of M&A versus Venture Capital, but the Duck Creek investors don’t all look like traditional VC’s. Another way to read the rivalry is one of hedge finance versus corporate finance. The appeal of reinsurance for hedge funds drove a lot of connections into the insurance industry that had typically been the domain of corporate finance. Now the pendulum appears to be swinging back to corporate.
One way this occurs is through captive insurance. A group or a single insured can set of their own insurance company to underwrite risks, and it turns out that with all the cash on their balance sheets, companies are doing a lot more of it. To some degree, that’s good news for both Duck Creek and Majesco, but because they leverage different relationships, that could be especially good news for Majesco. And what better way to get exposure to insurance without making a bet on either perils or interest rates, which have been hammering the industry from both sides.
Speaking of perils, ransomeware is on the rise. As Byrne Hobart pointed out in The Diff the game theory here points to an escaltory cycle of payouts and increasing cyber attacks. Cyber risks have traditionally been high frequency, low severity. This created little demand for cyber insurance. However, as severity increases, so does demand.
One of my favorite insurance books, Acts of God and Man, has a figure I’ve recreated that outlines this nicely. Below you can see, starting in the bottom right corner, that most organizations have worked to control or diversify against cyber risks, but as security programs improve and penalties increase in the middle of the chart, insurance becomes more attractive for the insured. As we move to the top left, insurance becomes less attractive as tail risks dominate.
The same book on insurance separates financial risks into those that are correlated with the market (non-aloof) and those that are not (aloof). It is a key feature of insurance that investors can get returns that while correlated within the asset class, are not generally correlated with other asset classes. This drives investors towards stories that are novel enough to explore, but comfortable enough to exploit. Software, as we saw in Duck Creek’s case, offers comfortable symbolic manipulation, yet exciting new business models.
FinTech & GovSec
One such business model is enabled by algorithmic scale. Network effects work when each new user improves the experience for all users. Getting the first users into the system is incredibly hard, but technological hacks offer a way. This is what Plaid did to build a network of banking API’s. As a startup you can take risks that others won’t. If it works out, you can bootstrap your way to legitimacy. Now the story comes full circle, as Wells Fargo shuts off screen scraping, closing the door to future Plaid competitors. Some innovation is basic science, but most is telling a new story.
One story making the rounds these days is that stock exchanges are ripping you off. How you are being ripped off depends on who you are. Venture Capital thinks IPO’s leave money on the table, so they have the Long Term Stock Exchange. If you’re a bank, you think the market data is too expensive. So you have the MEMX. If you’re a high frequency trader, you don’t like the execution and fees, so you have MIAX Pearl.
With all the competition in their legacy business, it’s no wonder that Nasdaq is getting into a hot new market. A few months back, in what feels like a lifetime ago, pre-covid, Nasdaq made an investment in an anti-money (AML) laundering startup. Their timing couldn’t be better, as this both builds their regulatory moat and offers a new line of business. It’ doesn’t hurt that their biggest customers are on the hot seat.
The Treasury Department is rolling out a new AML rules aimed at better customer due diligence, especially in notoriously murky markets like cryptocurrency and real estate. Elsewhere, the Treasury Department is also overwhelmed with efforts to track cyber attacks and coordinate cyber defense across the sector. On the bright side, it appears we’re still in the complexity phase of these frauds.
Know Thyself
The Oracle at Delphi had three maxims:
Know thyself
Nothing in excess
Surety brings ruin
The Oracle in Silicon Valley is proving that it knows what business it is in, and where not to go to excesses. The third maxim, what today I’d call, “don’t make promises you can’t keep” also holds true, as it looks that the deal has changed considerably since Microsoft was interested. Don’t fret for Microsoft though, they’ve been staying plenty busy.
Microsoft Moves
First, Microsoft has brokered an exclusive language generation license for GPT-3. So far GPT-3 has been all story, so despite the ire of Elon Musk, this may be a bigger win for OpenAI than Microsoft. Landing a flagship client who has the ability to co-develop and improve the product can turn a story into reality.
Microsoft has been active in cyber lately as well, backing the call from the Cyberspace Solarium Commission for a Cyber Czar. At the same time, Microsoft’s Chief Information Security Officer claimed that defenders have beter tools than ever. While this is certainly true, the juxtaposition of these two statements by Microsoft underscores just how pernicious a threat cybersecurity is. It has all the worst features of the tragedy of the commons and the only solution to coordination seems to be more bureaucracy. Tragedies are one of the few stories in the normal range.
Spectrum
Another tragedy of the commons, broadband spectrum, made news this past month. The bidding war for C-Band spectrum is heating up, as the savvy T-Mobile CEO predicted. The story that leads to exuberance and bubble prices is usually a triangle. Just a dialog can create a bidding war between rivals, but for irrational expectations to take hold a bit of envy helps, and nothing creates a winner’s curse like a love triangle.
AT&T and Verizon going to war because they are secretly jealous of T-Mobile’s sub-6 GHz spectrum (more than both of theirs combined!) is better suited for the coming 5G battle. This means the stakes are even higher, and bidding could create a windfall for the FCC. It’s unclear where that money will go, but at least some will likely go to build out rural networks, while the majority will be used to pay down U.S. debt.
Power, Petroleum and Processors
The other industry most famous for the winner’s curse, is oil. In fact, BP claims that oil companies may soon be divesting $111 Billion of oil and gas assets. Whether they will have overpaid for those assets or not is yet to be determined. What we do know is that Master Limited Partnership allowed oil and gas companies massive tax advantages if they derived 90% of their revenue from commodities, natural resources, or real estate leading them to shed their profitable intangible asset businesses like energy trading.
It turns out that trading oil is sometimes way more profitable than drilling for it. While the feel good story of responding to global pressure and regulatory demands is nice, the facts on the ground are that sometimes you can make so much money virtually that it’s not even worth the tax breaks to do things in the real world.
Energy in the real world is fraught with risk. There are of course wildfires, and foreign governments, not to mention the looming possibility of cyber attacks. This raise the difficult problem of whether to shame carelessness or not. The Nuclear (NERC) and Federal (FERC) Energy Regulatory Commissions (respectively) are walking back a policy to name and shame poor stewards. Without much needed visibility, state power regulators won’t be able to take utilities to task, but with too much disclosure it could create more opportunities for geopolitical rivals. In these a classic disclosure vs security trade offs, security nearly always wins the short run, only increasing the chance of catastrophic risk down the road. The key to resolving this problem will be finding a new way to tell the story as Palantir has done in intelligence.
A New Front
In closing this month, I wanted to draw attention to the conflict between Armenia and Azerbaijan that has recently picked up. I don’t have anything clever to say here. Just that this is far bigger news than most people would assume, and is a major fault line between Eastern Christianity and Islam. Turkey and Russia are already fighting two proxy wars, and a third, close to Iran, is a bad story.
Until next time, find me on Twitter @robterrin and please send any risk stories or feedback my way!