It has been a momentous year for our country. Absolutely no one on the face of the planet could have predicted on January 1, 2008 the events that would unfold in the next twelve months. We are in the midst of an extreme Black Swan. No one saw it coming and no one knows what will happen next. When plans to save the financial world every other weekend are slapped together, the law of unintended consequences is likely to rear its ugly head. It is hard to step back and try to understand what is going on at this point in history. What I do know is that whatever is happening is not good.
“Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ….I shiver at the thought.”
Nicholas Taleb shivered at the thought two years ago when he wrote these words in his book The Black Swan. Now the whole world is shivering, as the threat of a global collapse has never been closer. The last global collapse led to the Great Depression which lasted from 1929 until our entry into World War II in 1941.
THEY KNOW NOTHING!!!! THEY KNOW NOTHING!!!!
These were the words of Jim Cramer one year ago. He was referring to the Federal Reserve. Today those words apply to the Federal Reserve, Treasury, Congress, CEOs, Financial gurus, Larry Kudlow, Ben Stein, Fund managers, and Average Americans. Anyone who tells you confidently what will happen tomorrow, next week, or next year is either a fool or a liar. The same people who never saw this crisis coming certainly can not be trusted to tell you when it will subside. No one knows. Our political and financial “leaders” have absolutely no credibility left at this point. No one in government or in the financial community can be trusted to tell the truth at this point in history. Our financial system needs trust to function. The greed and phenomenally excessive risk taking by these “Masters of the Universe” at our “prestigious” financial institutions and regulators asleep at the switch led to possibly the greatest financial collapse in history. Our worldwide system of finance was on the brink of imploding.
The world is in the midst of a Black Swan event. People who fail to recognize what is happening or deny that it is happening will suffer the catastrophic consequences. Nassim Nicholas Taleb, in his brilliant irreverent book The Black Swan, published in 2007, contends that the world only changes during these events. According to Taleb a Black Swan event has three attributes:
1. It is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.
2. It carries an extreme impact.
3. In spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.
Taleb makes the case that most “experts” believe we live in a normal distribution world, when the world is really dominated by Black Swan events. These are events that should occur rarely in the long tail of the normal distribution curve. Based on the last ten years, I would have to agree with Mr. Taleb:
1998 Long Term Capital Management
2000 Dot Com Bubble
2001 9/11 Attack
2005 Housing Bubble
2008 Financial Implosion
I believe that these extreme events are interrelated and have built upon each other to leave us in the precarious position that we find ourselves. With five outlier events in ten years, we’ve become the “Black Swan Nation”. There are both positive and negative Black Swans. Examples of positive Black Swans are the invention of the Internet, planes, automobiles, and discovery of penicillin. The Dot-Com bubble and the Housing bubble gave people an opportunity to benefit, if you sold at the high. Still, more people have been hurt than helped by these events. You can not stop a Black Swan event but you can position yourself to benefit from a positive Black Swan or to avoid the pain of a negative Black Swan. An example of positioning yourself for a positive Black Swan is investing in venture capital firms that fund biotech or technology firms. If one of these companies discovers a cure for cancer, you will be rich beyond your dreams. A country can also position itself to bear the brunt of a massive negative Black Swan. Our government’s response to each ensuing Black Swan event insured that the current crisis would be of epic proportions. The common thread and cause of much of the pain today is former Federal Reserve Chairman Alan Greenspan.
Long Term Capital Management
Long Term Capital Management was a hedge fund founded in 1994 by John Meriwether. Myron Scholes and Robert C. Merton, winners of the Nobel Prize in Economics in 1997, developed the “scientific” models that the fund utilized to outsmart the entire financial community. The fund generated 40% annual returns in its first two years. The partners treated other financial institutions with disdain and their hubris grew to epic proportions. Nassim Nicholas Taleb compared LTCM’s strategies to “picking up pennies in front of a steamroller”. They generated many likely small gains, balanced against the unlikely chance of a large loss. The steamroller won in 1998. Taleb describes what happened next.
“Then, during the summer of 1998, a combination of large events, triggered by a Russian financial crisis, took place that lay outside their models. It was a Black Swan. LTCM went bust and almost took down the entire financial system with it, as the exposures were massive. Since their models ruled out the possibility of large deviations, they allowed themselves to take a monstrous amount of risk.”
All of their finely modeled bets went bad at the same time. The disdain they had showed to other financial firms was returned in kind. Other banks knew their positions and made them feel the pain. LTCM had so many positions with so many counterparties throughout the world that they became the 1st firm to be “TOO BIG TO FAIL”. They managed to lose $4.6 billion in three months. The Federal Reserve Bank of New York convened a weekend meeting of the CEOs of all the major Wall Street firms. They were heavily pressured to bailout LTCM. Ultimately, fourteen banks contributed $3.625 billion and received a 90% share in the fund and potentially averted a worldwide financial collapse.
Alan Greenspan, supporting this bailout, decreased interest rates twice in late 1998. In front of a Congressional committee in October, Alan Greenspan had this to say:
“It was a rare occasion, warranted because of the potential for serious disruptions to markets. Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations including our own.”