Black and White Swans: The Financial Panic of 2008 and Some Brazilian Lessons of 1975

From Nassim Taleb (author of “The Black Swan”): I am interested in how to live in a world we don’t understand very well –in other words, while most human thought (particularly since the enlightenment) has focused us on how to turn knowledge into decisions, I am interested in how to turn lack of information, lack of understanding, and lack of “knowledge” into decisions. My last book The Black Swan drew a map of what we don’t understand. For the last few years, I have been telling anyone who would listen to me that we are taking huge risks and massive exposure to rare events.  The Black Swan is a philosophy book, but I used banks as a particularly worrisome case of epistemic arrogance –and the use of “science” to measure the risk of rare events, making society dependent on very spurious measurements. To me a banking crisis –worse than what we have ever seen — was unavoidable and NOT A BLACK SWAN, just as a drunk and incompetent pilot would eventually crash the plane.”

From the book “The Black Swan”: 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 crises 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…Banks hire dull people and train them to be even duller. If they look conservative, it’s only because their loans go bust on rare, very rare occasions. But bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug.

Bankers are dull and not conservative? Is the financial panic of 2008 a white swan? In other words: highly probable or possible? Should it have been expected? We start from here and naturally offer some Brazilian stories and examples.

Oil prices went down from US$ 150 to 60; Dow-Jones index fell from 14,000 to 8,500; Bovespa declined from 70,000 to 35,000; the Brazilian real went up (devaluation) from 1.5 to 2.3, all in a period of three months. On the other hand, it took more than five years for oil prices to go up from US$ 30 to 150, for the Dow-Jones to grow 100%, for the Bovespa to jump 200%, and for the Brazilian exchange rate to appreciate from 3 to 1.5.

Many analysts are reading Hyman Minsky again, who wrote about cycles during the golden era of Keynes. And now let us consider the story of the swans of Taleb, an epistemologist.

As a matter of fact, it does not matter to point out peaks and valleys because time is of the essence. Anyone who predicted a world recession in 2006 – including a housing bubble all over the world – missed the peaks for more than 24 months and probably would be short of money to bet on the white (or black?) swan of 2008.

Is it really true that we understand the financial system? After all, the swan is black or white? Who are these dull bankers? Are we talking about bank executives or bank shareholders – or bank clients?

In 1975, the Central Bank of Brazil found out that some financial institutions were leveraging more than 100 times without any regulation (and without financial derivatives at that time), buying long-term Federal Government bonds and financing the positions on a day-by-day basis, that is, overnight. An amazing carry-trade. In 2008, the Federal Reserve also found out huge leverage ratios. And let us make sure that we are talking about the “best” financial institutions (two good examples: Banco Garantia in Brazil and Goldman Sachs in the USA).

At that time (1975), Brazilians felt that this was a Brazilian “invention”, but nothing was far from the truth. Inflation and interest rate variability created such opportunities. In 2008, rather than inflation, interest rate differentials and exchange rate fluctuations generated very similar situations. Borrow with the currency with very low interest rates and invest in financial assets with high yield currencies or in the stock market of such countries.

Without simplifying things too much, a financial institution in 2008 in the USA or Europe or Asia is basically a hedge fund doing proprietary trading with high leverage. Just like the Brazilian “hedge funds” of 1975 (namely, brokerage houses). Big risks, big returns on equity: due to leverage plus interest differentials plus or minus exchange fluctuations. It is just a question of doing the math: with a leverage of 50, a monthly exchange fluctuation of 1% (in your favor) and an interest rate differential of 1%, one gains 100% in 30 days – or one disappears if the exchange rate goes 2% in the wrong direction.

This is clearly a black swan. Something very difficult to understand. Why bank shareholders and/or bank clients accept such risks? The answer is of course in a major asymmetric distortion of the gains and losses in hedge funds and financial institutions. The performance fees and the bonuses. One gets 20% if everything goes well, and zero if things go wrong (no penalties).

Such incentive system was naturally created or invented by bank executives and fund managers: only gains, nothing to lose (except the job perhaps). Rather than investing the capital of the bank (as a bank executive), use intensely other people’s money and keep 20% of the profits. Just like a black swan, it is very difficult to understand why bank clients and/or bank shareholders would allow bank executives (and this can be translated to fund managers) to gain such bonuses and performance fees. Asymmetry of risks.

Going back again to the Brazilian lessons of 1975, there was a major mitigation for the risks then: it was not in the interest of the Brazilian Central Bank to let the dealers go broke and, consequently, at some difficult situation the financial institutions could always sell their positions back to the Government.

Nowadays, in 2008, at least until September (before Lehman), it was a zero-sum game. But the asymmetrical distribution of profits was maintained. Bank executives – the non-conservative “bankers” of Taleb – get performance fees and bonuses when things go well and lose nothing when there are no gains.

The irrationality of the system of bonuses and performance fees is difficult to reconcile with the basic concepts of rationality in economic theory (such as “more is preferred to less”). However, it is practically impossible through regulation to avoid high leverage ratios (good examples: Brazilian brokers in 1975 and non-bank companies all over the world in 2008).

This is the name of the swan: LB – leverage and bonus. And the dilemma or trade-off exists because of such irrational scheme: it has nothing to do with regulation, it should have something to do with competition, but this would require us to assume, however, than men are rational.

Perhaps the attempt made by Taleb to study finance and epistemology should go further into the realm of the duration of our memories. Germany defaulted in the 20’s, but was selling bonds again ten years later. Brazil defaulted in the 80’s, but was again active in the market in the late nineties. In the next few years, some hedge funds will disappear (as well of course as some financial institutions), but greed will make clients and shareholders act strangely and irrationally, as a herd of cattle, even with the “cost” of paying 20% performance fees (for the fund manager) or 20% bonus (for the bank executive) as soon as they find out that a certain new financial investment is producing 100% in one month – and this is so “easy” to do with the right combination of leverage and financial differentials, neglecting of course frauds such as the old Ponzi scheme.

But perhaps the financial system is in fact a huge Ponzi scheme – a point made by Minsky when we reach the negative side of the cycle –  simply because the institutions borrow short and lend long, which means that the bicycle has to keep moving, hopefully with leverage and bonuses.

There is no doubt that in 2008 many fell off from the bicycles – the managers of this big hedge fund and the bank executives of this big “bank”. The fund and the bank might as well be called: The Black Swan(s).

2 Responses to "Black and White Swans: The Financial Panic of 2008 and Some Brazilian Lessons of 1975"

  1. WiseGuy   November 13, 2008 at 10:59 am

    Great article! I have not read the books by Taleb, so I’m at a disadvantage. Hopefully I will have a chance to review them one day.I believe much of the “patterns” observed in our financial system are results of flocking behavior — which is not deterministic (although it appears deterministic at times). The nature of the system is chaotic. Put another way, the signal-to-noise ratio is nearly zero.Unfortunately, people (myself included) seem to have an overly tuned sense of seeing patterns where there aren’t any.

  2. 2cents   November 13, 2008 at 11:39 am

    Very insightful. … You have wisdom beyond your years.