DSI Global View White Paper – The Next Black Swan?

March 21, 2011, Chicago, Illinois USA –

Nassim Nicholas Taleb is the Lebanese philosopher, writer and mathematical financier who wrote the 2007 book The Black Swan, which has been called one of the most influential books written since World War II. I have found that precious few people have actually read this book.

Taleb regards almost all major disasters, scientific discoveries, historical events, and artistic accomplishments as “Black Swans” – unpredictable and unplanned. The invention of the printing press, air travel, the Internet, the personal computer, World Wars, the 9/11 attacks, the recent uprisings in the Arab world, and the Japanese triad of the March 11th 9.0 earthquake, tsunami and nuclear power plant failures are all examples of Black Swan events.

Taleb went on to criticize the global finance industry and warned about future financial crises. He advocates what he terms a “black swan robust” society, meaning a society that can withstand difficult-to-predict events. Put simply, if something can happen – it will. Or put even more tragically, if you cannot imagine anything worse, expect something worst to happen. It is just a matter of time.

Mega Black Swan

We have had two financial Black Swans in the past few years; one a macro event and the other at the micro level. The macro event was the 2007 financial meltdown of the mega-banks precipitated by their securitization of sub-prime mortgages into investment vehicles sold around the world. In the US alone, nearly 7.2 million “high-interest” or sub-prime loans were made between 2005 through 2007, the bell curve of the sub-prime boom. The 25 top originators of these high-interest loans, totaling nearly $1 trillion, wrote 72 per cent of what Warren Buffett famously called, “financial weapons of mass destruction.”

The 2007 Black Swan had many moving pieces. Complicit in this Rico-esque conspiracy were: (1) the Fed policy of printing dollars to fuel the mortgage boom; (2) the implicit government guarantees standing behind Fannie Mae and Freddie Mac that enabled these two mortgage giants to dominate the $12 trillion US mortgage market; (3) the Fannie and Freddie top executives who made generous political contributions to “guardian angel” Congressional politicians to ensure favorable legislation, ineffectual Federal regulatory oversight and unfettered access to the markets; (4) scores of mortgage companies like Countrywide that made billions in fees writing loans they then flipped to unsuspecting investors; (5) the investment banks that designed, sold and subsequently bailed out of contaminated sub-prime derivatives, and (6) huge insurance companies such as AIG that made billions selling credit default swaps insuring these securitized mortgage vehicles while failing to adequately reserve for the defaults to come.

Similar events unfolded in Europe as Iceland, Greece, Ireland, the UK, Spain and Eastern Europe also experienced cheap money bubbles. The big mega-bank traders in essence priced sovereign bonds perfectly for the giant economies of Germany and France, but the broad homogeneous impact of a Euro still in its infancy also led these markets to under-price risk for the region’s weaker economies. The big banks bought EU bonds from weaker countries which injected that cheap money into their respective real estate markets or banking systems to make risky loans.

When the crash came, rather than let the mega-banks and Goldman Sachs of the world take their lumps, the US and EU intervened, bailing out the finance industry with public money. The experts advising these governments that this course of action was absolutely necessary were the very same bankers that precipitated the crisis. This is akin to the fox in the hen house assuring the farmer that it is OK to bring in more hens.

Micro Black Swan

The micro Black Swan was the so-called Flash Crash of May 6, 2010, when the Dow Jones Industrial Average plummeted 1,000 points in 20 minutes. This forced the NYSE to suspend trading and invalidate certain trades based on completely arbitrary factors. Some investors experienced windfalls while others lost.

To date, we do not know exactly what happened on that day, or rather the NYSE will not tell us what happened. The culprit vaguely offered up is High-Frequency Trading (HFT) using supercomputers and algorithms to make millions of trades in and out of the markets in milliseconds.

HFT firms are mostly privately held. They have no clients and they trade using their own capital. They are unregulated. Their business models are based entirely on exploiting minute flaws in electronic market systems. To achieve speed, these firms build their supercomputer facilities literally meters way from the exchanges they seek to exploit.

For example, in Tseung Kwan O, a town connected to Kowloon, a new data center is being built where HFTs can place their computers in immediate proximity to the Hong Kong Exchange’s computer systems, thereby shaving milliseconds off their trades and beating other systems to the market. This is called “co-location” and similar centers are being built next to all major exchanges world-wide, including NYSE Euronext, the National Stock Exchange in India and the ASX in Australia.

HFTs’ private, unregulated status compounds doubts about market depth of liquidity, stability, transparency and fairness. Tabb Group, a consulting firm, estimates that HFTs accounted for 56% of all US equity trades and 38% of European trades (by value) in 2010. Add this to the proliferation of markets worldwide, independent markets run by banks and brokers, and “dark pools” established to handle large blocks of shares off-market and you have to ask yourself, “Who is the sucker sitting at the table?” The sucker sitting at the table is you.

HFTs are inherently predatory and exploitative. They distort faith in orderly and fair markets. They drive retail investors from the field and ultimately diminish liquidity for all. The exchanges of course maintain that they can detect such schemes and that they have controls in place. But why allow co-location to begin with? Hockey, for example, has a rule for Offsides. A team cannot station a player in front of the opposing goal, because this gives the team an unfair advantage. Co-location is exactly like that. Why do the exchanges allow co-location to provide HFTs unfair advantages in the capital markets?

Some in the HFT business argue that no evidence suggests their millisecond trading cyclones are harmful to markets. But of course there is no evidence to explain exactly what benefit they provide to markets either.  What is true is that trading volumes are falling, as market markers seek less manipulated private arenas, such as the recent Facebook private placement by Goldman Sachs.

Inflation – The Next Black Swan

What is interesting about these two financial Black Swans is how little has been done to ensure that neither will happen again. Hedge-fund manager Paul Singer believes that mega-banks worldwide are heading towards another financial meltdown. Inflation will be the culprit this time around. The bank bailouts and worldwide sovereign debt crisis were fueled by governments printing money: these same governments are still printing.

You may remember that Paul Singer made billions of dollars by shorting the sub-prime mortgage market ahead of the meltdown. He saw the meltdown coming and attempted to warn regulators of what was to come. Today Singer views money-printing by the Fed, the EU (and China behind closed doors) as the harbinger of another Black Swan.

“In effect they’re treating confidence in fiat money – in paper money – as inexhaustible, that it’s a tool that’s able to be used not just in the throes of crisis,” said Singer. He says governments act as if printing money is, “a virtually complete substitute for sound fiscal regulatory and taxing policy.”

Commodity prices worldwide are soaring as a result. Following decades of oppression, recently skyrocketing food prices have spontaneously triggered social uprisings across the Arab world. Inflation has triggered revolt. After all, printing money inflates all assets. Gold isn’t expensive: currencies are cheap.

As commodities go, so go wages, and the escalating spiral of inflation is ignited. Instead of decoupling the mega-banks from “too big to fail” symbiotic governmental “sugar daddy” relationships, nations have involved themselves more heavily in the loop. Hence the US Federal government implicitly is backstopping individual states that essentially are bankrupt while the EU has backstopped the PIIGS (Portugal, Italy, Ireland, Greece and Spain).

Credit ratings are subjective and too easily manipulated. Does anyone really believe the EU bank stress test results? Does anyone really believe that the billions of loans made by the politically directed Chinese banking system are collectible? Does anyone really believe that the US will not step in again if Citibank, Morgan Stanley or Bank of America steps over the line? In these arenas, moral risks generate Black Swans.

So the next Black Swan event could be a series of interrelated bad decisions that result in an epic market failure. Inflation will impact markets, causing borrowers to default. Governments may be tempted to print more money to sustain the unsustainable. Politicians will decide which big institutions should “survive.” The survival or collapse of major international firms will be entirely arbitrary, as was the case with the government and big labor take-over of General Motors and Chrysler, or conversely with the collapse of Lehman Brothers. Smaller companies afloat on a rising inflationary tsunami will be swept aside.

In the final analysis, the lack of clear and sound fiscal policies among nations, coupled with the reckless printing of money to “kick the can down the road,” plus governmental subjective decisions regarding which firms are or are not “systemically important” will send the Black Swan flying again. I can think of no better definition of Russian roulette.

Richard Wottrich, Blog Author – rwottrich@mcleanllc.com – Joe Loughran, Editor – jloughran@mcleanllc.com – Katie Merchent, Editor – kmerchent@mcleanllc.com