The Financial Crisis is Not a Black Swan Event

I have become increasingly concerned that some in the Obama administration are treating this economic crisis as a Black Swan event. Nassim Nicholas Taleb coined the term to describe an event that is very rare, random and unpredictable. The imporant thing about Black Swans is that, because they are random and unpredictable, you can’t stop them from happening; you can only create your systems able to handle Black Swans if they occur. For example, a flu pandemic that kills tens of millions might be a Black Swan, and it’s one that we’re completely unprepared for, as we don’t have the excess medical capacity to handle it.

The most recent event which made me think of Black Swans is the news thatnew SEC Chair Mary Schapiro doesn’t plan on reforming ratings agencies. Now, ratings agencies were one of the key actors in this mess—they certified mortgage backed securities and other toxic derivatives as AAA quality. If they had not done so, almost no one would have bought them.

The ratings agencies are paid by the companies whose securities they rate. I trust you see the problem.

If you think that the current economic crisis is just random, a once in a century disaster (or at least once every few decades), then you won’t think making major changes is necessary. Get through the problem, go back to how you were doing things before, and everything will be fine.

But, of course, the economic and financial crisis unfolding right now was not random. This crisis was predicted by multiple people, and it was predicted because of policy steps taken by government and widely-known private actions.

We could all read the charts showing a bubble in housing prices and sales. We could all see that derivatives were also in a bubble. We knew that leverage was out of control, ballooning to 30X or in many cases even higher numbers. We knew that with financial deregulation firms had started being involved in multiple types of businesses, putting retail banks at risk from their insurance or brokerage or investment banking arms. We all knew that the US savings rate had hit unsustainable lows and that the trade deficit was too high. We knew that the carry trade was introducing tons of hot money to the system (borrowing for nothing in Japan and using that money for leveraged plays elsewhere).

And, perhaps most importantly, we should have known that executives in the financial sector paying themselves huge bonuses were concentrating on short term gains and did not care about long term viability of their companies or even care about the honesty of what they were doing, because hey, by the time it all fell apart, they’d be rich, rich, rich and never need to work again.

All of which is to say the crisis was caused by a number of factors. It was not random. It was predictable and predicted. If we just muddle through this current meltdown—spend a lot of money bailing out the banks, throw some stimulus around—and don’t fix the fundamentally-flawed incentives and structures of the system, it will likely happen again.

Alas, Mary Schapiro’s actions imply that there was nothing really fundamentally wrong with how business was done.

At the very least, the US needs to make the following changes:

Reduce executive compensation—significantly,

Bring all securities under regulation (i.e. Credit Default Swaps must be regulated as insurance including reserve requirements and the necessity to use government approved actuarial charts),

Reduce overall leverage to 10X for everyone,

Break financial companies back into functional firms (i.e. break brokerages and insurance companies and investment banks off of retail banks),

Disallow financial innovation which is not expressly approved by regulators and is not then fully regulated,

Fix its trade imbalances,

Fix its savings rate,

Move off of the oil economy,

Ensure that lending is done responsibly and at relatively low markups from the Fed Funds rate, and

Enact anti-usury laws.

If these changes aren’t made, then you can bet dollars to the donuts that a financial crisis will happen again in some form. This crisis is a structural problem, not a random mess caused by bad luck.

Originally Posted at FDL, February 19th, 2009. I’d say nothing has changed, but in fact it has, we now know pretty much for certain that the Obama administration thinks this is a Black Swan event. The Geithner plan makes that very clear.