Risky Finance 21 May 2008

Nassim Taleb’s avian metaphor may have helped sell a lot of books. But when it comes to the credit crunch, it lets people off the hook. The time has come to shoot the black swan.

If there is one image that for many characterises the modern financier brought low, it is the computerised model of the future, blindsided by sudden unexpected market events. The image has been around at least since the LTCM blow-up in 1998, but much of its more recent potency is due to Taleb, a former hedge fund trader turned best-selling author.

With the help of pointed anecdotes about former acquaintances, leavened with philosophical references, Taleb pokes fun at those who get “fooled by randomness”, living in what he dubs the “mediocristan” of the Normal distribution. Fatally, these people think that the past will resemble the present—which is like inferring that all swans are white when that is the only colour of swan you have encountered.

Then comes the market equivalent of an earthquake or typhoon and the fools with their Normal distributions get swept away—into the ranks of the unemployed at least. But left standing, not just unscathed but enriched by the cataclysm, is the sceptical believer in outlandish and unanticipated events, epitomised with no room for doubt by Taleb himself.

The eponymous hero lives in what Taleb calls “extremistan”, the kind of edgy, post-9/11 neologism that worked so well in the George W Bush era. Expressed as a trading strategy, believers should buy out-of-the-money options on the basis that the Normal distribution encourages mispricing. According to a recent Bloomberg Magazine profile, Taleb had mixed results using this strategy, closing down his hedge fund in 2004.

In the credit crunch, Taleb ought to be in his element. With CDO portfolios being suddenly written down to zero, and fifteen-standard deviation events galore, black swans seem to be everywhere. Volatility has spiked up and buyers of out-the-money-options have done well. But the tropes about extreme events and unknown risks have a strangely ritualistic air in the current environment.

Anyone who looks closely at the roots of the credit bubble soon discovers that flawed statistics—Taleb’s bugbear—had little to do with it. The problem begins at a more fundamental level, where probability emerges from peoples’ feelings about bets involving uncertainty.

Take that poster child of the bubble, the AAA-rated synthetic CDO. On one side were the investors who “hate to lose”—who feel much worse about the prospect of losing a bet than the pleasure they get from winning it. To persuade them to bet, their perceived probability of losing must be tiny. The CDO addressed this need.

On the other side were the CDO’s creators who “love to win”, the bankers who cared much more about winning their annual bonus than about losing their bank money. It was never a secret that the CDO had extreme loss characteristics that were truly ghastly compared with a vanilla credit. But the bankers found ways of hiding this ghastliness in SIVs and conduits that made the CDO bet compelling for them too.

Once this fundamental bet had been agreed between both sides, there was a need to dress it up with some objective validity. Banks paid rating agencies to perform this validation, and the agencies dutifully produced reams of default and correlation statistics showing the CDOs to be safe.

When things went sour, the compact between investors and bankers was exposed. Founded as it was on an emotional approach to probability, there is nothing to do but unwind it completely. The rating agencies that concealed the compact with flawed statistics are now in an uncomfortable position. They were paid so much money as the bubble grew that regulators are now convinced that they were part of the compact too.

Desperate not to acknowledge this, the rating agencies are producing mea culpas that are riddled with Taleb-style language. We weren’t corrupt, they say, but rather our statistical models that we deployed in good faith were caught out by black swans such as US subprime fraud. These arguments deserve the greatest scepticism.

As for Nassim Taleb, his books may continue to entertain. For small investors, the black swan has some value as a metaphor for their ignorance. But for the all-too-knowing players of the wholesale markets, it has literally become a get-out-of-jail-free card that hides culpability. Time, then, to roast the black swan on the fire.

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