Making sausages

As they saying goes, if you want to enjoy a sausage, it’s better not to know what’s in it

Author: David Orrell
March 4, 2013

Many European consumers were reminded of this fact – and not just for sausages – by the recent horsemeat scandal, which started in the UK when the Food Standards Agency discovered that some products such as frozen lasagnes and hamburgers were more horse than beef.

For a nation which loves horses, this came as something of a shock. Of course, the scandal posed a risk more to cultural prejudices than to the health of the population. However it is a reminder that modern supply chains offer society a high level of efficiency, with the drawback that we often have little clue what is going into the things we consume.

Such supply chains are often tortuosly complex: here it involved a French-owned factory in Luxembourg, another French company called Spanghero, a Cypriot trader, another trader in the Netherlands, and finally an abattoir in Romania. (The Romanians have since denied that the mislabelling originated with them.)

In earlier, simpler times, people would often obtain their mince by going to the butchers and asking for a specific piece of meat to be ground up. It would have been difficult to end up by accident with a piece of a different animal species from an Eastern European abbatoir. But today, rather than relying on our own eyes, we have to trust a hugely complex international supply chain. We believe (or accept) that the label on a product is accurate, and the contents have not been changed or substituted at any point in the chain, through error or fraud.

The processing and packaging also meant that the end purchaser had little idea what went into it, which left the system open to abuse

Food has all sorts of powerful cultural and emotional resonances, which is why the horse scandal got so much press. However the same kind of meat-mixing also occurs in other areas, such as financial products. Consider for example the changes in the U.S. mortgage industry which helped kick-off the financial crisis.

In earlier, simpler times (like the 1980s), mortgages were traditionally a straightforward bond between the home owner and a financial institution. A disadvantage of this arrangement was that the bonds were hard to trade, so banks had to keep the low-yielding liabilities on their books for a fixed term. To address this problem, in the 1990s they turned increasingly to methods such as collateralised debt obligations (CDOs).

CDOs consist of bundles of mortgages, which can then be divided into tranches of varying quality, and sold as separate instruments. On the surface, they offered a neat way to take a group of individual mortgages with different default risks and payment schedules, and homogenise them into an easily-traded, plastic-wrapped product with a tailored degree of risk.

The mortgage “supply chain” became increasingly complex and specialised. A broker would sell mortgages to home-owners. These mortages were then compiled by a mortgage bank; an investment bank would transform them into an investment product; another firm would be responsible for managing payment collection; and a rating agency would stamp the whole thing as grade A prime beef.

As with the food supply chain, this complexity led to some cost efficiencies, but also had the effect of severing the connection between mortgage supplier and home owner, so their interests were no longer aligned. The processing and packaging also meant that the end purchaser had little idea what went into it, which left the system open to abuse. The result was far more toxic than any equine lasagne.

Financial sausages
The people in charge of labelling this financial equivalent of mystery meat were the rating agencies such as Standard and Poor’s. The labelling acted as a reassurance that the product was safe. Unfortunately, these institutions didn’t do a very good job. The products again often turned out to contain more horse than beef.

Part of the problem was the mathematical models that were being used. These were based on historical records of volatility. Since the US housing market had been growing steadily for decades, it is no surprise that they underestimated the risk of default.

The rating agencies also had a blatant conflict of interest. In order for instruments such as CDOs to be attractive to investors, they needed to have a high rating, preferably triple-A. When the housing market started to tank in early 2007 (if not before), these ratings should have been adjusted down; but this would not have pleased clients such as major banks. So while the agencies were in theory objective and independent, they actually had a stake in keeping the ratings high in order to allow their clients to get the bonds off their books.

According to a recent US civil complaint against S&P, internal S&P documents show that the company regularly tweaked their models to give the right (ie triple-A) answers – which was nice for their clients, but less so for the purchaser. As Tony West from the US Justice Department put it, “It’s sort of like buying sausage from your favorite butcher, and he assures you the sausage was made fresh that morning and is safe. What he doesn’t tell you is that it was made with meat he knows is rotten and plans to throw out later that night.”

Globalisation in industries such as finance or food has been hugely beneficial in many respects. It is indeed a miracle that human beings spread over many different countries can conspire to make single products in such an efficient manner. But complex systems theory teaches us that efficiency often comes at the expense of robustness. A system which is highly efficient, and minimally regulated, may also be sensitive to small perturbations, or vulnerable to contagion. For this reason, many biological systems, such as those found in the human body, are far from paragons of efficiency. The regulatory bodies which provide a dgeree of oversight might make products more expensive – but as we are learning at the supermarket, you get what you pay for. And sometimes, it really is better to buy local.