A Really Black Swan

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NASSIM NICHOLAS TALEB (author of The Black Swan): “I don't know if we're entering the most difficult period since—not since the Great Depression, since the American Revolution.”
PAUL SOLMAN (National Public Radio): “The most serious situation we've been in since the American Revolution?”
NASSIM NICHOLAS TALEB: “Yes.”

Ten days ago, Nassim Taleb—who wrote The Black Swan: The Impact of the Highly Improbable—told NPR that we might be closer to the beginning of the global financial and economic turmoil than to the end. He said that the Treasury’s strategy of combining banks and other financial institutions into ever-larger organizations is creating the risk of a truly system-shaking event. He said we might have a black swan—something that can’t exist, because nothing in your experience that tells you it can—paddling towards us.

And that was after the Lehman collapse.

Lehman’s bankruptcy triggered the freeze-up of credit markets and created the need for the Paulson bailout—and all the other efforts—to keep the credit markets liquid and the big banks solvent.

However, Taleb was saying that it might not be enough or, perhaps, that the governments are fighting the last war…and not even preparing for the next.

As we describe in FLYP, the problem is that a vicious cycle of global deleveraging, credit re-pricing, and contracting consumer demand is creating new casualties practically every day. Banks, companies and households are shedding debt. Borrowers are increasingly unable to raise the money they need at rates they can afford. Foreclosures and bankruptcies are rising. And the pace at which the economy is slowing continues to accelerate: projects and purchases that seemed to make sense even a month ago are now being cancelled.

No one knows when this cycle will spin itself out.

Sure, the Treasury and Federal Reserve’s massive interventions are starting to work. The largest banks are again willing to trade with each other and companies like General Electric can get short-term credit. On the other hand, almost everybody else is being badly squeezed.

Nevertheless, that’s not a black swan. Until 17th-century European explorers found black swans in Australia, everyone (at least everyone in Europe) knew that swans could only be white.

By definition, you only recognize a black swan when you finally see one. But you can think about where to look for one. In the current crisis, one place to start might be to look at the unexpected (and still largely unexplained) ongoing deterioration of AIG.

Surprisingly, AIG has used about $84 billion of the $123 billion rescue package that saved the company from collapse in September. (The company had actually borrowed even more, but repaid about $5 million last week, when it was allowed to raise another $21 billion using a cheaper Fed guarantee program.)

This massive need for cash apparently reflects rapid deterioration in AIG’s portfolio of exotic financial instruments. These include insurance against default—so-called credit-default swaps—of mortgage-backed securities, the toxic assets that include pieces of subprime and other mortgages. As housing prices fall and foreclosures rise, bond defaults (or even the threat of defaults) are forcing AIG to put up cash against the insurance policies it wrote.

AIG’s potential exposure is massive: it wrote $447 billion of credit-default swaps. If even a fraction goes bad, the Treasury rescue would be overwhelmed.
Credit-default swaps work like life or fire insurance. In this case, lenders are buying insurance against the possible failure of a government or company to pay its debts. However, there are three big differences from the kind of insurance.
•    First, the credit-default market is entirely unregulated, thanks in large part to Phil Gramm and Alan Greenspan (see FLYP: Who Let the Dogs Out?). Some of the institutions that sold credit-default swaps —which include banks, hedge funds and insurance companies—might not have the resources to pay. Literally, no one knows.
•    Second, companies that sell credit-default swaps in turn buy other default swaps to offset their risk. This creates a worldwide chain of insurers and insured—and immense complexity.
•    Third, the market is massive: the gross value of credit-default swaps is at least $54 trillion (down from $62 trillion at the start of the year).

So, if a lot of companies (think General Motors) or governments (think Iceland) begin to default, the cost would be enormous. Even short of default, as the chance of defaults rise because of the weakening global economy, companies (like AIG) who wrote credit-default swaps are obligated to raise cash to show they could pay if they had to. That means selling more stocks (and other assets), which drives markets lower—and creates more uncertainty.

That might be why Taleb concluded his NPR interview this way:

“Now you understand why I'm worried. I hope I'm wrong. I wake up every morning—actually, I don't wake up every morning now. I start to wake up at night the last couple of weeks hoping that I'm wrong, begging to be wrong. I think that we may be experiencing something that is vastly worse than we think it is.”

– Alan Stoga