How Airlines Quietly Became Banks

- Airline loyalty programs were valued higher than the airlines themselves during the COVID-19 crisis. In 2020, United Airlines sought a $5 billion loan to survive the collapse in travel. Rather than pledge the struggling airline as collateral, it offered MileagePlus Holdings LLC, the subsidiary operating its frequent flyer program.

- United disclosed a $21.9 billion valuation for MileagePlus. In an SEC Form 8-K filing, the company explained that multiplying MileagePlus Holdings' 2019 EBITDA by 12 produced an approximate valuation of $21.9 billion.

- Delta and American disclosed similarly extraordinary loyalty-program valuations. Delta's frequent flyer program was valued at approximately $26 billion, while American Airlines' AAdvantage program was valued at approximately $31.5 billion.

- The loyalty-program valuations exceeded the airlines' stock-market values. At the time, United's market capitalization was approximately $10 billion, Delta's was $20 billion, and American's was just $6 billion. Each airline's loyalty program was therefore valued above the entire publicly traded company.

- The valuations suggested that the transportation businesses were worth less than their loyalty programs. The speaker argues that, according to these comparisons, the underlying airlines effectively had negative value, with their loyalty businesses providing the principal source of corporate value. These figures were collateral valuations compared against market capitalizations, rather than proof of independently established negative business valuations.

- American Airlines demonstrated how unprofitable transportation could coexist with substantial corporate profits. In 2018, the airline generated approximately 14.42 cents in passenger revenue per available seat-mile while spending 14.85 cents to operate that seat-mile. It therefore lost roughly 0.43 cents on every seat-mile flown.

- American nevertheless reported $1.9 billion in pre-tax profits, supported by $4.2 billion in frequent flyer program revenue. The speaker uses these figures to illustrate how loyalty-related revenue could compensate for losses in the airline's core transportation operations.

- Airports and aircraft have increasingly become marketing channels for financial products. Airlines advertise co-branded credit cards, offer lounges and priority services to loyalty members, and encourage elite-status enrollment. Flight attendants even deliver credit-card sales pitches during flights, sometimes receiving commissions for successful sign-ups.

- Airlines increasingly operate like financial institutions rather than conventional transportation companies. Their passenger experience is designed partly to encourage credit-card applications, loyalty enrollment and spending through financial partners. The speaker argues that airlines have deliberately developed a business model in which losing money on transportation can be worthwhile if it supports a more profitable loyalty business.

- Frequent flyer programs began as straightforward customer-reward schemes. The concept resembled a sandwich-shop punch card: customers accumulated rewards through repeated purchases and eventually received a free flight.

- American airline deregulation in 1978 made formal frequent flyer programs technically and legally possible. Airlines had already begun tracking individual passenger activity, but deregulation helped create the conditions for structured loyalty programs.

- Texas International established the first frequent flyer program. The small airline subsequently became part of Continental through a merger. American Airlines introduced the first program among major long-haul carriers in 1981.

- American Airlines discovered that loyalty members were more likely to choose its flights. AAdvantage members wanted to accumulate enough miles for free travel and were reportedly willing to pay approximately 5% more for an American flight than an equivalent United flight because the United flight would not advance their American mileage balance.

- Accumulated points created customer lock-in through the sunk-cost effect. Someone with 10,000 AAdvantage miles would prefer to continue flying American to reach the 12,500-mile threshold for a free domestic flight rather than start accumulating rewards with another airline. The existing balance influenced purchasing decisions even when competing flights offered equivalent value.

- The original loyalty programs generated more additional revenue than they cost airlines. Although providing free flights involved expenses, American quickly recognized that customer retention and increased willingness to spend outweighed the costs of operating the program.

- American expanded AAdvantage beyond airline purchases in 1982. It partnered with Hertz and Holland America, allowing members to earn frequent flyer points when renting cars or booking cruises.

- The important innovation was that airlines began selling their loyalty points to commercial partners. American could not simply distribute miles whenever customers spent money elsewhere because redeeming those miles created costs for the airline, including the opportunity cost of giving away seats that might otherwise have been sold to paying passengers.

- American therefore assigned a monetary price to its previously abstract loyalty points. Although the actual commercial pricing arrangements were closely guarded, the transcript gives an estimated example of American selling a point to Hertz for one cent. Hertz could then distribute those points to customers to encourage them to rent from Hertz rather than competing companies.

- The economics of purchased points could be extremely attractive to airlines. At an assumed purchase price of one cent per point, 25,000 points would generate $250 in revenue for American. The transcript compares this with an approximately $15 variable operating cost for a typical domestic flight, illustrating the potential profitability of partner-funded award travel.

- American introduced a major new source of loyalty revenue through its 1987 partnership with Citibank. The co-branded credit card allowed customers to earn one American Airlines point for every dollar spent on the card.

- Credit-card partnerships transformed frequent flyer programs into independent profit centers. Rather than simply rewarding people for purchasing airline tickets, airlines could sell enormous quantities of points to banks and other partners, generating revenue from spending that had nothing to do with buying airfare.

- Frequent flyer points generally receive favorable tax treatment. Governments typically regard them as rebates or discounts on purchases rather than taxable income. Because customers must spend money to earn points and cannot officially exchange them directly for cash, the rewards are generally treated like ordinary purchase discounts.

- The tax treatment makes loyalty rewards particularly attractive to customers and airlines. A person receiving points that can later be redeemed for free flights generally does not pay income tax on the value of those rewards under the treatment described in the conversation.

- Business travel creates a financial arrangement in which the person earning the points is often not paying for the flight. Employers pay for their employees' business travel, but frequent flyer points are awarded to the individual passenger rather than the company financing the trip.

- Employees can accumulate two separate streams of rewards from company travel. They receive airline loyalty points for flying and may also receive credit-card points when the airfare is purchased using their company card.

- Employers generally tolerate employees keeping business-travel rewards. The speaker explains that business travel has become less glamorous, and companies are willing to let employees accumulate points for personal leisure travel in exchange for undertaking work-related trips.

- Company travel policies can indirectly subsidize individual loyalty rewards. Employees might have incentives to choose a more expensive airline or spend more on a company-funded trip to accumulate additional rewards. The speaker notes that most companies do not appear particularly concerned about this possibility.

- Tax treatment and employer policies both strengthen airline loyalty businesses. Airlines receive money from employers, employees and credit-card partners while the individual traveler receives the loyalty benefits, creating a system in which several parties support the same rewards economy.

- The original distance-based earning system created an exploitable weakness. As airline revenue-management systems became more sophisticated, ticket prices increasingly reflected demand and customer willingness to pay rather than simply flight distance.

- Flights covering identical distances could have substantially different ticket prices. The transcript gives American Airlines' Washington-to-Nantucket and Washington-to-Boston routes as an example. Both cover approximately 400 miles, but the lowest Nantucket fare was $98, compared with $49 for Boston.

- Airlines charged more for Nantucket because its travelers were considered more willing to pay for convenience. Nantucket attracts wealthier vacation travelers, making nonstop flights more commercially valuable than equivalent-distance flights to Boston.

- Distance-based mileage rewards failed to account for differences in ticket prices. Under the traditional one-mile-one-point approach, passengers earned approximately 400 points on either 400-mile flight, despite paying potentially twice as much for one of them.

- Cheap, indirect itineraries could generate disproportionately large loyalty rewards. A passenger flying from Los Angeles to San Francisco through Chicago could earn approximately ten times as many points as someone taking the direct flight, despite potentially paying less for the longer itinerary.

- Airlines were effectively rewarding customers for choosing less efficient journeys. Longer itineraries required additional flights and operating expenses while generating more miles that could eventually be redeemed. The original distance-based system therefore sometimes encouraged behavior contrary to airline profitability.

- Airlines responded by replacing distance-based earning with revenue-based earning. Over approximately the preceding decade, nearly every major frequent flyer program had moved toward awarding points according to the amount customers spent rather than the distance they traveled.

- The Big Three US airlines adopted a straightforward spending-based model. American, United and Delta award approximately five points for every dollar spent under the earning structure described in the transcript.

- Revenue-based earning largely eliminated opportunities to exploit mileage accumulation. Spending more produces more points, while purchasing a cheaper long-distance itinerary no longer automatically generates a disproportionately large reward.

- Airlines also redesigned award redemption to eliminate opportunities for customers to obtain unusually valuable flights. Previously, United charged 12,500 points for an economy-class flight anywhere within the continental United States, regardless of the travel date.

- Fixed award prices could cost airlines significant revenue on high-demand travel dates. A flight on the Sunday after Thanksgiving could have an extremely high cash fare because almost every seat was likely to sell, yet a successful award booking still required only 12,500 points.

- Award seats carried an opportunity cost that fixed redemption rates did not adequately reflect. Giving away a seat during a high-demand period meant potentially sacrificing a valuable cash-paying passenger, even if the same award redemption made economic sense on a quieter Tuesday.

- Airlines introduced dynamic award pricing to align redemption costs with demand. Nearly every major airline now adjusts the number of points required for a flight in much the same way that cash ticket prices change with demand.

- United's October 2022 Newark-to-Denver fares illustrate the change. A nonstop flight cost $114 on a low-demand Tuesday and $254 on a high-demand Sunday.

- The same United flights required substantially different numbers of award points. The Tuesday flight required 8,300 points, while the Sunday flight required 22,200 points, an increase of approximately 2.7 times.

- Dynamic award pricing brought point redemption rates closer to the underlying cash prices. By adjusting both earning and redemption according to spending and demand, airlines largely eliminated the possibility of exploiting mismatches between cash fares and mileage rewards.

- Airlines have effectively closed the major loopholes on both sides of their loyalty systems. Customers can no longer reliably accumulate disproportionately valuable miles through cheap, long-distance itineraries or redeem fixed-price awards for unusually expensive flights.

- The principal remaining constraint on loyalty-program economics is the price commercial partners are willing to pay for points. Credit-card companies and other marketing partners must decide how much a point is worth to them, based partly on what customers believe they can receive in return.

- Travel and financial websites publish estimated valuations to help consumers judge their redemptions. These estimates provide an informal market reference for the perceived value of different airline currencies.

- American's AAdvantage points received the highest average valuation among the three major programs. Aggregating five published estimates, the transcript gives the following average values:

• Delta SkyMiles: 1.218 cents per point.
• United MileagePlus: 1.226 cents per point.
• American AAdvantage: 1.416 cents per point.

- Higher perceived point values can make American's loyalty program more attractive to customers and commercial partners. Consumers may be more inclined to fly American, use its co-branded credit cards or transfer other reward points into AAdvantage. If partners distribute their existing inventory of American points more quickly, they may need to purchase additional points.

- Airlines retain considerable negotiating power over credit-card companies. The US market has only three major long-haul airlines but many potential financial partners, creating an imbalance in the number of available airline partnerships versus interested financial institutions.

- The existing major partnerships connect each airline to a principal banking partner. United works with Chase, American with Citibank, and Delta with American Express.

- Airlines can potentially replace banking partners that refuse to pay higher prices for points. Bank of America, Barclays, Capital One and Discover are among the alternative institutions that could benefit from securing a major airline partnership.

- The threat of replacing a credit-card partner strengthens airlines' bargaining positions. Financial institutions compete for access to airline loyalty currencies because those partnerships provide valuable customer acquisition and spending opportunities.

- Airline loyalty programs function like privately controlled central banks issuing virtual currencies. Airlines determine how many points enter circulation, how many are sold to commercial partners and the conditions under which customers can redeem them.

- Airlines possess an additional source of power that conventional central banks do not. They control not only the supply of their virtual currency but also the availability of the goods and services customers can purchase with it, particularly award seats on their own flights.

- Airlines can create additional points and sell them to commercial partners. Unlike a conventional currency issuer, they also operate the principal system through which those points acquire practical redemption value.

- The airline effectively controls the conversion between its points and real-world travel. Customers cannot officially exchange the points directly for cash; the airline determines what flights are available, how many points they require and when redemption is permitted.

- The combination of currency issuance, redemption control and commercial point sales makes frequent flyer programs unusually powerful financial instruments. Airlines control both the virtual money and the inventory available to spend it on, while earning substantial revenue from banks and other partners purchasing that currency.

- The central argument is that airlines have built a business model in which loyalty programs can be more valuable than the transportation operations supporting them. Their ability to issue points, sell them to financial partners, influence customer behavior and control redemption gives them a highly profitable business that can remain attractive even when flying passengers itself produces weak or negative margins.