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

by: James Quinn

[Read Part I]

9/11 Attack

As Nicholas Taleb points out, human beings always try to rationalize a Black Swan event after the fact. If it was predictable, it wouldn’t happen.

“A vicious black swan has an additional elusive property: Its very unexpectedness helps create the conditions for it to occur. Had a terrorist attack been a conceivable risk on Sept. 10, 2001, it would likely not have happened. Jet fighters would have been on alert to intercept hijacked planes, airplanes would have had locks on their cockpit doors, airports would have carefully checked all passenger luggage. None of that happened, of course, until after 9/11”.

Following the September 11, 2001 attack the Greenspan led Fed voted to reduce the federal funds rate from 3.5% to 3.0%. As the Enron scandal and other corporate misdeeds of 2002 developed, the Fed dropped the federal funds rate to 1.0%. He then left rates at this level for over a year. Greenspan acknowledged that this drop in rates would have the effect of leading to a surge in home sales and refinancing.
"Besides sustaining the demand for new construction, mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that homeowners have built up over the years."

The only problem was that Americans extracted $3 trillion in equity from their homes and spent it on BMWs, HDTVs, exotic vacations, and whatever other selfish pursuits that appealed to them.

The national reaction to the 9/11 disaster was one of unity of purpose. We wanted to find and punish the terrorists that caused this tragedy. A call for national sacrifice would have been heeded. Instead, George Bush and Alan Greenspan encouraged Americans to teach the terrorists a lesson by spending. In June of 2001, prior to the attacks, a $1.35 trillion tax cut was enacted, including $50 billion in rebate checks. After the attacks, General Motors showed their patriotic spirit by offering 0% financing on all cars. Big ticket retailers offered easy credit and extended terms so that everyone could have a flat screen HDTV and worry about paying later. Consumers started a buying frenzy that didn’t stop until credit evaporated in 2008.

George Bush did his part to stimulate the defense industry by starting an unprovoked war that has already cost the country $700 billion, 4,100 needless deaths, and 30,000 wounded. Estimates of the total cost have risen to $3 trillion.The Bush administration estimated the cost at $50 billion before the war. The lesson is that when the government provides an estimate, multiply it by 10 to get closer to the truth. Trust in the government began to evaporate rapidly after the Iraq debacle. As Alan Greenspan denies causing the housing crisis today, his words from November 2002 come back to haunt him, “our extraordinary housing boom…financed by very large increases in mortgage debt, cannot continue indefinitely into the future.” He then proceeded to reduce interest rates to 1%, spurring the biggest bubble in history.

Click to enlarge

Never has a graph told a story more completely than Professor Shiller’s, from his book Irrational Exuberance. Between 1998 and 2006 home values virtually doubled. There is no logical explanation for this occurrence. Previous peaks were 60% lower than the peak reached in 2006. This chart is very similar to the NASDAQ 5,000 chart. After viewing this chart, any reasonable person would conclude with absolute certainty that home values would fall steeply for a long time. Too bad the reasonable people didn’t include Alan Greenspan, Bank CEOs, Mortgage companies, Rating Agencies, Homebuilders, Treasury Secretaries, Presidents, Regulators, or Congressmen. They not only didn’t see the fall coming, they spiked the punch bowl and encouraged the party to kick it up a notch. The following words from, former CEO of Citigroup, Charles Prince in July 2007 will be immortalized alongside Gordon Gekko’s “greed is good” speech:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

He is now doing the Rumba in the Old Bank CEO “retirement” home along with James Cayne, Ken Thompson, Angelo Mozilo, Daniel Mudd, Richard Syron, Dick Fuld and Kerry Killinger. And things are now somewhat complicated.

Robert Shiller’s expert opinion regarding the 2005 Black Swan in real estate was:
“Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national obsession is poker.”
Much of the housing frenzy can be attributed to homeowners getting caught up in the media hype and the cascade of information about others getting rich buying and selling houses. But, Greenspan's 1% interest rates were the fuel for the frenzy. He knew exactly what these rates would do when he said the following words in 2005:

"Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission." 

The final nail in the coffin of Greenspan’s legacy was his speech in February 2004. Greenspan suggested that more homeowners should consider taking out Adjustable Rate Mortgages. The Fed funds rate was at an all-time-low of 1%. A few months after his recommendation, Greenspan began raising interest rates, in a series of rate hikes that would bring the funds rate to 5.25% about two years later. Greenspan's advice came at a time when interest rates had bottomed out making it a particularly bad time to take out an ARM. The triggering factor in the current crisis was the many subprime ARMs that reset at much higher interest rates than what the borrower paid during the first few years of the mortgage. Greenspan gave the bad advice and Wall Street provided the money and derivative products which have created our worldwide meltdown.

Financial Implosion

Warren Buffett’s view of derivatives in his 2002 Annual Letter to shareholders:
“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.

Warren didn’t know what would happen or when it would happen, but being the smartest financial mind on the planet enabled him to foresee a bleak outcome. Based on the chart below, which strangely resembles the NASDAQ chart and the Home Value chart, a reasonable person could conclude that this credit derivative bubble would not end well. Another Black Swan was coming, but again the Harvard educated CEOs on Wall Street making $15 million per year did not see it coming or chose to ignore the risks because they knew that the Federal Reserve and the Government would come to the rescue if they went too far. The Greenspan “put” was well known on Wall Street. Whenever someone did something stupid and risked worldwide financial collapse, the Fed would ride in on their white horse to save the day. Alan Greenspan and the Federal government had created a moral hazard by their actions during the previous Black Swan events. Since Wall Street knew they would be bailed out, they took colossal risks in the last few years.

Worldwide sales of CDOs exceeded $500 billion in 2007. The following excerpts from a Bloomberg magazine article in June 2007, before the crisis began, lays out the story of recklessness and greed of the bank executives, and pension fund managers regarding  these “financial weapons of mass destruction”.

Because CDO contents are secretive, fund managers can't easily track the value of the components that go into these bundles. ``You need to monitor the collateral in your investment and make sure you're comfortable there will be no defaults,'' says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis. Most investors can't do that because it's extremely difficult to track the contents of any CDO or its current value, he says. About half of all CDOs sold in the U.S. in 2006 were loaded with subprime mortgage debt, according to Moody's and Morgan Stanley. Since CDO managers can change the contents of a CDO after it's sold, investors may not know how much subprime risk they face, Das says.

At a sales presentation of the bank's CDOs to 50 public pension fund managers in a Las Vegas hotel ballroom, Jean Fleischhacker, Bear Stearns senior managing director, tells fund managers they can get a 20 percent annual return from the bottom level of a CDO. ``It has a very high cash yield to it,'' Fleischhacker says at the March convention. ``I think a lot of people are confused about what this product is and how it works.'' The California Public Employees' Retirement System, the nation's largest public pension fund, has invested $140 million in such unrated CDO portions, according to data Calpers provided in response to a public records request. Citigroup Inc., the largest U.S. bank, sold the tranches to Calpers. Edward Altman, director of the Fixed Income and Credit Markets program at New York University's Salomon Center for the Study of Financial Institutions said ``That's obviously a very risky play. If there's a meltdown, which I expect, it will hit those tranches first.'' Calpers spokesman Clark McKinley declined to comment.

It is quite interesting that the head of Calpers was on CNBC this past week in the midst of the crisis railing against short sellers as the cause of the market meltdown. The citizens of California should throw this bozo out on his behind for taking extraordinary risk with their money. His fury against short sellers was a smokescreen to cover up his own incompetence.

Again, Alan Greenspan contributed his two cents by praising the rise of the subprime mortgage industry and the tools it used to assess credit-worthiness in an April 2005 speech at the very peak of the housing frenzy:

"Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country … With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. … Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s."

The SEC essentially abdicated their role of regulator and protector of individual investors in 2004. An exemption for 5 investment banks (Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley) allowed them to take the kind of risks which have collapsed the worldwide financial system. According to Lee Pickard, former director of the SEC trading and markets division:

The losses incurred by Bear Stearns and other large broker-dealers were not caused by "rumors" or a "crisis of confidence," but rather by inadequate net capital and the lack of constraints on the incurring of debt.
 
The events of the past year were avoidable. A conscious and willful decision by the SEC to allow these 5 firms to legally violate existing net capital rules in place since 1975, which had limited broker/dealers debt-to-net capital ratio to 12 to 1 is a major cause of the financial collapse. Instead, the 2004 exemption allowed these 5 firms to leverage up 40 to 1. Mr. Pickard concluded, "The SEC modification in 2004 is the primary reason for all of the losses that have occurred. The proof is in the pudding — three of the five broker-dealers have blown up."

In his continual effort to keep his legacy from going up in smoke,  Alan Greenspan wrote an article in March 2008 for the Financial Times’ Economists’ Forum entitled “We will never have a perfect model of risk“, in which he argued:

"We will never be able to anticipate all discontinuities in financial markets.” It is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation, not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.”

In a scathing rebuttal to the article, Paul de Grauwe, wrote:

“Greenspan’s article is a smokescreen to hide his own responsibility in making the financial crisis possible. Greenspan, who was at the helm of the most important monetary institution in the world, failed to take his responsibility to supervise the financial markets blinded as he, and his colleagues, were by a belief that markets and bankers know better than governments.”

The Conservative mantra of total deregulation has been catastrophically discredited and practically brought down the whole worldwide financial system. The pundits, like Larry Kudlow, who proclaim that free market capitalism is the best path to prosperity, are now in favor of the weekly bailout packages for their buddies on Wall Street. This flip-flop in their regulation mantra has resulted in their total loss of credibility.

In very simplistic terms, this crisis can be summed up in one sentence.
If you loan money to people or companies that cannot pay you back, you will go bankrupt, unless your Country bails you out.

The brilliant Merrill Lynch Bank of America economist David Rosenberg predicted what was going to happen in December 2007:

“The bottom line is that all those McMansions that were bought during this housing boom are going to go the way of the 1973 Lincoln Continental, The housing bubble was the most over-owned, overleveraged and oversupplied real-estate market ever,  and its unwinding will take years. The revival of consumers saving their money for retirement - rather than expecting their homes to provide the cushion - added with ‘move down’ buyers will depress real-estate prices.”

What Do We Know Today

On Wednesday afternoon Harry Reid, Democratic Senate Majority Leader, spoke the first truthful word from a politician during this entire crisis:

"No one knows what to do. We are in new territory here. This is a different game."

I respect him for this comment. We have been listening to Hank Paulson tell us that our banking system was sound for over a year. He was the CEO of Goldman Sachs. He knew the extreme risk taking that was going on. He was lying to the American public. Today, he is being hailed as a hero in saving our country. We should be very careful in declaring men such as Paulson a hero. Union Colonel Joshua Chamberlin, who led his men in a charge down Little Round Top at the Battle of Gettysburg and saved the Union army, is a hero. Hank Paulson, has committed our future generations to trillions in obligations for the sins of his buddies on Wall Street. I know many heroes, and Hank Paulson is no hero.
Nicolas Taleb poses the following questions:

Why don't we realize that we are not that capable of predicting? Why don't we notice the bias that causes us not to realize that we're not learning from our experiences? Why do we still keep going as if we understand them?

f our business leaders and government leaders had learned from the LTCM collapse and NASDAQ collapse, we would not be experiencing this current crisis. Instead, Wall Street, Alan Greenspan, George Bush’s administration, and Congress attempted to put off the pain of recession by encouraging more risk taking by companies and citizens. We are now reaping what they have sown.

This has been a remarkable year. The United States has taken actions that will change our country forever. They have taken these actions without citizens voting or Congress passing any laws debated upon in public view.  These actions have taken place behind closed doors and in conjunction with the bank CEOs who caused the problems. A multi-millionaire former investment banker, former professor of economics, and our 1st Harvard MBA President have committed at least ONE TRILLION of our future tax dollars to bailing out greedy incompetent criminal millionaire investment bankers. They have done this to avert an Armageddon type financial meltdown. I’m reminded of the rhetoric about weapons of mass destruction before our attack of Iraq. We needed to attack to avert a future nuclear holocaust. Why should we believe them now? Hank Paulson and Ben Bernanke’s commitment of your grandchildren’s future so far is as follows:

Bear Stearns Rescue                    $29 billion
Tax rebates to Americans              $168 billion
Fannie Mae & Freddie Mac nationalization          $300 billion
AIG nationalization                        $58 billion
Government taking bad debt off U.S. banks' books        $700 billion

FUTURE GENERATION’S BILL        $1,255,000,000,000

Remember, when the government gives you an estimated cost, it is always prudent to multiply it by 10 to get closer to the truth.

Let us be perfectly clear. The U.S. government has no money. We entered this week with a National Debt of $9.65 trillion. The deficit for next year will surpass $600 billion. Every dime of these bailouts will be borrowed. They will be borrowed from China, Japan, and the Middle East. In an effort to keep our corrupt financial system afloat, we have sold another piece of our country. The prestige and status of the U.S. in the eyes of the world community have suffered a catastrophic non-reversible decline in the last nine months. “We The People” had absolutely no say in this decision.

My final musings on what has transpired over the last nine months are as follows:

•    The people who made the miscalculations that got the country into this mess are the same people who did not see it coming, denied it was a big problem, and have now come up with the solution to the problem. This should not give Americans a tremendous feeling of confidence in their government.
•    The government has used all the missiles in Hank Paulson’s bazooka. What if it doesn’t work? What next? I shiver at the thought.
•    The Republican ideology of deregulation and free markets has been discredited and thrown into the scrap heap of history. The total lack of regulation in the financial industry let the inmates run the asylum and almost collapsed our financial system.
•    The Democratic ideology of believing that every American should own a home has proven to be one of the stupidest ideas in the history of our country. The housing implosion, which continues today, proves that many morons in this country should rent forever.
•    The current crisis proves that a “village idiot” could have done less damage to our country if they had been CEO of any of our financial institutions, rather than the Harvard MBAs now in charge. Their total lack of foresight, vision, strategy, or risk management argues for the elimination of the immoral pay packages of all CEOs. The greed and short term profit motives of these CEOs and top executives leads to awful decision making with tragic consequences.
•    Reliance on computer models developed by brilliant “scientists” that can predict all outcomes in a “Normal Distribution” world should be discredited at this point. Human emotions and Black Swans have proven more powerful than any computer model. How about using thoughtful conservative assumptions regarding any financial transaction. I know, that sounds crazy.
•    Financial institutions should not create instruments that are so complicated that they can’t even understand them.
•    I hate to quote Richard Nixon, but when he was told that some corporate goliath was “too big to fail” he responded, “Tell it to get smaller”. I am tired of hearing that every company that has a problem is too big to fail. The government cannot let any company become too big to fail. But, of course they just encouraged Bank of America to buy Merrill Lynch and become way too big to fail.
•    A total scraping of the bond rating system is in order. The companies receiving the ratings cannot be compensating the rating agencies. The false credit ratings misled so many into a false sense of security and contributed greatly to this financial debacle.
•    It should be clear to the American people that the $1.255 trillion will be borrowed from the Chinese, Russians, Japanese, and Middle East. The United States of America is broke. We have no money. The annual interest charge that the American people will pay will exceed $60 billion per year, $164 million per day, $6.8 million per hour.
•    As all Americans know, when you borrow from someone, they call the shots. The reckless mismanagement of our country’s finances has put us in the position of asking other countries for favors. We are now begging for capital infusions from China. The Chinese and Middle Eastern countries know they are gaining more power, day by day. The U.S. Empire has begun its long slow decline.
•    The old dilemma for a country was whether they could fund guns or butter. When the U.S. tried to fund both in the late 1960’s and early 1970’s it resulted in massive inflation and a stagflation economy. With our current foreign wars, massive unfunded liabilities, promised tax cuts from both candidates, and now the greatest bank bailout in history, we are trying to fund guns, butter, and banks simultaneously. The massive issuance of Treasury bills should result in much higher interest rates.
•    Consumer confidence and trust in their government will fall, not rise because of the actions taken this week. Your leaders have lied and misled you. The massive redemptions from money markets were not panic. It was a rational response to being misled by bankers that money markets were safe and could not lose money.
•    Based on the actions taken to relieve banks of all their bad debt, American citizens may come to the conclusion that they don’t need to honor their own obligations. The moral hazard message from our leaders is that bad decisions do not have bad consequences.
•    Does anyone really think that government will run Fannie, Freddie, and AIG better than they were run by their previous management? Will Hank Paulson hire the same Wall Street cronies to manage his new investment portfolio?
•    Comparing this new RTC to the original RTC used for the S&L crisis seems too simplistic. Bill Siedman, head of the original RTC, described his job as fairly easy and it took six years to complete. His job was to sell off land from bankrupt S&Ls. This new RTC will be taking toxic waste mortgage debt off the books of the banks. I doubt there will be a line waiting to buy this crap.
•    With congressional leaders like Christopher Dodd, Chuck Schumer, and Barney Frank in charge during the next term I’m not confident that we will avoid another negative Black Swan. They have all shown a complete lack of basic financial knowledge.
•    Will the government ban all selling if the market continues to fall? Banning short-selling could result in unforeseen results. China has not banned short selling. We certainly won’t see any short covering rallies. It is ironic that naked short selling by Merrill, Lehman, Goldman, and Morgan Stanley was extremely profitable for these firms over the last few years.
•    The rhetoric about these programs lasting only until 2010 is a farce. These programs will end up becoming a permanent department. Government never contracts. It only expands.
•    Any legislation that is slapped together in the midst of a crisis with an extremely tight timeline will be flawed and not well thought out. There will be mistakes, omissions and holes. Let’s hope it doesn’t cause another Black Swan to develop.

Hopefully, our citizens will come to their senses and elect more patriots like Ron Paul, whose words in Congress on September 10, 2003 foretold the future crisis:

“Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing. Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary, but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.”