In the Midst of an Extreme Black Swan (Part I)

by: James Quinn

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 nine 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.


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.”

These words seem strangely familiar to what we heard from Hank Paulson this past week.

Greenspan ruled out direct regulation of hedge funds, saying it was possible to monitor the fund's activity and act when necessary. Moral hazard was born during this crisis. Well meaning members of the Congressional committee had a different opinion. The rescue raised "troubling questions of financial concentration and antitrust," Mr Leach said at the hearing. "As a group working together, the new owners can have a greater impact on markets than in competition with one another." Representative Bernard Sanders of Vermont, the House's lone independent, called it a "bailout for billionaires" that rewarded "the gambling practices of the Wall Street elites."

This first Black Swan event should have been a warning to the ruling elite of Wall Street, Congress, Greenspan, and the American people. No one heeded the warning. Firms were allowed to get bigger, the CEOs of the firms took on greater risks, Greenspan and Congress delegated their regulator responsibilities to the free market. Ten years later, the same problems have occurred to a much greater degree. The government is trying to avert worldwide financial collapse on a daily basis.

Dot Com Bubble

The NASDAQ market, consisting of smaller growth companies, in January 1995 was at the 750 level. On March 10, 2000 the market peaked at 5,132, an increase of 584% in five years. On January 1, 1995, I can assure you that no one predicted this rise. It was an extreme outlier and the reasons for the rise were concocted after the bubble popped. In a speech during 1996 Alan Greenspan warned that the U.S. economy was suffering from “Irrational Exuberance”. The following day, the stock market dropped significantly. Mr. Greenspan never used the term again. As the economy heated up in the late 1990’s and Wall Street started pushing IPOs like, Greenspan did not do what a Federal Reserve Chairman should have done, take away the punch bowl before the party got out of hand. If he had increased margin requirements, day traders wouldn’t have had the money to propel the markets to ridiculous heights. As a political animal, Greenspan did not increase interest rates leading up to the November 1999 Presidential elections in support of the current Clinton administration. As the year 2000 approached and the ridiculous fears of computers around the world no longer functioning led people to hoard cash and supplies of water, Mr. Greenspan opened up the spigots and flooded the economy with cash. This cash immediately flowed into stocks and pushed the NASDAQ to its epic peak, a level that not will be seen again for decades.

Robert Shiller, professor at Yale, published his book Irrational Exuberance in early 2000. In this book he poked holes in all of the Wall Street rational for stocks being as high as they were. His contention was that a feedback loop based on emotion led to this dramatic rise in the stock market. He effectively concluded that the “efficient market theory” was a load of crap. His own words were a little more professorial.

"The high recent valuations in the stock market have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgment of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom."

In the real world, people are not rational machines like Merton and Scholes believed. You can not model human behavior and capture the emotions that drive people to do certain things. This is very disappointing to academics and “scientists” at investment banks. Wall Street gurus declared that it was different this time. The internet era would usher in permanently higher profits and productivity. Once this lie had been perpetuated, Wall Street proceeded to fleece the public by doing initial public offerings of any ridiculous concept with a .com at the end of its name. Many of the IPOs soared by 500% to 1,000% on the day they were issued as day traders used margin to pump and dump these stocks. Average people gave up their jobs to day trade. backed raised $82.5 million in an IPO in February 2000 before collapsing nine months later. Online grocer Webvan raised $375 million in an IPO. Webvan came to be worth $1.2 billion (or $30 per share at its peak). The company closed in July 2001, putting 2,000 out of work. raised $166 million in a May 1999 IPO, but in the course of 16 months, its stock went from a high of $84 per share in October 1999 to a low of just 9 cents per share in February 2001. The event that marked the top was the acquisition of Time Warner by AOL in January 2000.

Professor Shiller’s opening question was: "Are powerful fundamental factors at work to keep the market as high as it is now... or is the market high only because of some irrational exuberance -- wishful thinking on the part of investors that blinds us to the truth of our situation?"

Professor Shiller then proceeded to methodically and convincingly prove that the market was grossly overvalued by every measurement used throughout the history of the stock market. The PE of the market reached 45 in early 2000. At the peak before the 1929 Crash, the PE had reached 35. There was absolutely no doubt that this bubble would pop. S&P earnings had fluctuated in a fairly narrow range throughout history, and have always reverted to the mean. By 2000, a complete disconnect had occurred between earnings and the level of the stock market. Shiller argued that “positive feedback loops” among investors led to herd like behavior and created a “naturally occurring Ponzi process”.

All previous speculative peaks in 1901, 1929, and 1966 had resulted in subpar stock returns for the two decades following the peak. The peak reached in March 2000 far exceeded any previous peak in history. Millions of people piled into the stock market because they saw the media touting the success of others. A sort of collective delusion overcame the country. Shiller concluded that "The high recent valuations in the stock market have come about for no good reasons." He was right. The Dot-com bubble crash wiped out $5 trillion in market value of technology companies from March 2000 to October 2002. Communications companies overburdened by massive amounts of debt filed for bankruptcy. WorldCom, run by Bernie Ebbers, was found to have used illegal accounting practices to overstate its profits by billions of dollars. The company's stock crashed when these irregularities were revealed, and within days it filed the largest corporate bankruptcy in U.S. history. Ebbers went to prison. Wall Street “analysts” were discredited and some were prosecuted for touting worthless stocks as buys.

The trigger for the collapse was the six interest rate increases by Alan Greenspan in late 1999 and early 2000. He continued to increase rates until they reached 6% by late 2000. The collapse of the internet bubble, the resulting reduction in business activity, and the increase in interest rates combined to push the country into recession. Alan Greenspan and George Bush have one thing in common, they don’t believe in recessions. Greenspan rapidly decreased the Fed discount rate from 6% to 3.5% by September 2001.

Read PART 2 >