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The IRA was on the road last week, visiting clients and business partners in the U.K. and taking in the local color. The people who live and work in London seem at least as stressed out as their counterparts in the New York metroplex, in part because the actual (as opposed to official) inflation rate is even higher in the UK than in places like New York - and this despite the strength of the pound.

One of the benefits of international air travel is the opportunity to read the books and periodicals which fail to reach the top of the queue during the work week. Some of these, particularly Nassim Taleb's new volume, The Black Swan, cause us to reflect on the state of things in the world of risk management.

Taleb uses the singular imagery of a Black Swan to describe rare events, those infrequent, unfamiliar occurrences which take investors and markets by surprise and have a disproportionately large effect on history compared with the total number of events. He then goes on to describe how the natural human tendency for summation, the unconscious habit to assign patterns to random data points and then create narratives to describe these patterns, makes us focus on the mundane and ignore (or miss entirely) the extraordinary. For Taleb, reading the newspaper is the worst way for a risk manager to be informed.

In between portions of Black Swan, we tasted selections from a couple of issues of the New York Review of Books. The June 28 issue includes a review of Steven Johnson's book, The Ghost Map, which describes the cholera epidemics in London a century ago and how researchers eventually solved the problem not by direct observation of events, which involve humans dying horribly of extreme dehydration, but by studying the geographic distribution of mortality data.

At the start of the 19th century, societies in most European cities had forgotten the civil engineering lessons learned by the Greeks and Romans centuries before. The great cities were sweltering nexuses of disease and lacked basic sewage and sanitation infrastructure. Residents threw excrement and garbage into the streets, or stored same in the cellars of their homes.

"The situation was alarming not only for the obvious reasons but also because the prevailing theory at the time held that diseases were caused not by germs but by 'miasmas' -- the bad smells emitted by rotting animal and vegetable matter," the reviewer observed.

As tens of thousands of London residents fell ill and died from the ravages of cholera, the UK medical establishment - a wonderful allegory for today's risk managers - insisted that there was no connection between the mounting pollution of the city's water supplies and the disease. At the time, doctors frequently treated cholera victims with hideous "cures" such as enemas of turpentine and ground mutton.

As London grew and the cholera epidemics became more frequent, social activists demanded the creation of crude sewers to carry waste into the River Thames, which was and is today also London's primary source of drinking water. But these early attempts to rid the city of miasmas by dumping untreated human waste into the Thames actually accelerated the problem. London's leaders, you see, still did not understand that cholera was spread via water rather than through the air.

Only when the weight of evidence, supported by meticulously kept death records, demonstrated that people living in towns were more prone to cholera and, in particular, that access to water sources downstream from London were connected with very high incidents of cholera, did the city's leaders slowly make changes to eradicate the disease by building proper civil sanitation.

Connect Taleb's admonition about the nature of knowledge and the pitfalls of reaching conclusions which are not well-supported by relevant data with the history of London's cholera epidemics, and a troubling parallel emerges. Think of the medical experts of 1840s London as today's risk practitioners, confident in their quantitative models and the adequacy of their market data, and caustically critical of any and all who question the efficacy of contemporary risk methods.

Taleb writes that we all labor under "the illusion of understanding or how everyone thinks he knows what is going on in a world that is more complicated (or random) than they realize." That observation is applicable to both the citizens of 1840s London and a trader in the credit derivatives market.

For example, ask most risk professionals today why the U.S. equity markets have been rising steadily and most would answer that cheap, plentiful credit c/o the Federal Reserve Board is the chief factor, an explanation repeated by the sheep in the big media over and over again.

But our friend David Kotok of Cumberland Advisors suggests that the prospective changes in tax laws may be a bigger - and largely unanticipated factor - in driving U.S. equity markets lower. It seems that U.S. corporations have been offshore cash balances to fund the nearly $1 trillion in stock repurchases since mid-2004, cash balances for which no U.S. tax has been paid.

"Until last week, stock buybacks were considered routine," Kotok writes. "Not much attention had been paid to the source of the funds. Then IBM announced a $12.5 billion stock buyback. That changed everything. The Internal Revenue Service (NYSE:IRS) realized that IBM was using money from its foreign subsidiaries to fund the buybacks. This money has not been taxed by the United States. Normally foreign subsidiary income does not get taxed by the IRS until it is repatriated. IBM estimated they were saving $1.6 billion by using this method."

"The IRS moved quickly and by surprise," Kotok continues. "IBM announced its plan on May 29th. The IRS publicized the regulatory change on May 31st. IBM is the last large American company to get under the wire."

Just as the leading lights of the U.K. medical establishment once thought that cholera was an airborne contagion, risk professionals and regulators alike rely upon tools based upon statistical simulations and market data which do not adequately describe or measure credit and market risk, much less operational risk events like changes in tax law.

Indeed, returning to Taleb's warning about the pernicious effects of reading the financial press, a process he argues desensitizes risk managers to the full range of available data points and thus possible outcomes, we wonder if the "mega" market and credit risk events such as Amaranth and LTCM really are the outliers.

What if events such as the implosion of a $10 billion asset hedge fund are residents of the commonplace sector Taleb calls "Mediocrastan," while the true outliers, such as a shift in the political equation of a city like Washington or London, are far, far larger? For the U.S. equity markets, how many standard deviations from the mean is the IRS decision regarding IBM's share buybacks?

Or to quote Taleb: "The inability to predict outliers implies the inability to predict the course of history, given the share of these events in the dynamics of events."

Source: Black Swan Hunting: Equity Markets and Random Events