The Days of the Black Swan And the Illusion of Predictability
O. Max Gardner III

Well over a year into the mortgage crisis, the problems just keep getting worse and worse. The first to take the blame were consumers who allegedly took out the sub-prime loans they could not afford to repay. Once this myth was debunked, the blamed then focused on to the front-line Main Street lenders, the national mortgage originators and the financial-oriented investment vehicles such as the hedge funds and the real estate investment trusts. The failure of the two Bear Stearns Cayman Island hedge funds in June of 2007 was a clear call that the financial crisis was in fact a financial epidemic. The next victims were the Wall Street underwriters and investment bankers followed by the Government Sponsored Enterprises--Fannie Mae and Freddie Mac.

The so-called mortgage crisis is now called a credit contagion because it has impacted almost every form of credit, not just residential mortgages. It has spread into other areas of the United States economy such as the financing of commercial real estate, automobiles and other consumer products. The severity of this storm and the speed with which it hit largely defies description, but words such as surreal, frightening and unprecedented have been used by various commentators.

The unprecedented downward spiral of the economy has also served to undermine a basic tenant of the American financial system. This tenant provides that we know how the financial systems operate and can successfully predict how they will perform in the future. The implosion of a myriad of securitization structures undermines the efficacy and legitimacy of the future performance ratings that were originally assigned to these structures by the so-called rating agencies. These agencies employed historical financial models and data to predict how non-traditional and indeed totally different financial products would perform in the future. And, as it turned out, they were wrong. They were not just wrong they were dead wrong.

The financial implosion was first explained as a sub-prime crisis that was caused by and limited to a few individuals who faked their incomes in order to borrow more money than they could ever repay. We now know that the fundamental problems with our current economic system resulted from a massive ponzi or pyramid scheme developed and implemented by some of the most sophisiticated Wall Street investors. The sub-prime myth was just that—fiction. We are now dealing with some degree of reality. Such words as collateral debt obligations, credit default swaps, collateral debt obligations squared, synthetic derivates and notational values are now discussed in the main-stream media much like the sales figures for Ford and Chevy trucks.

The future has always proved to be much crazier that any of us ever thought it would be. Popular culture likes to cite the famous quote by Yogi Berra: “The future ain’t what it used to be.” What Yogi was really talking about was what in philosophy is now referred to as the Black Swan problem. The Black Swan theory has been described as the impact of the improbable on present events.

Before the discovery of Australia, the world had no reason to believe that swans were any color other than white. The sighting of a single black swan in Australia eliminated thousands of years of reasoning and thinking and most importantly predictability. Simply stated, the appearance of a single black swan in Australia conclusively established that you cannot use history to predict with certainty the future. This event also demonstrated the power of randomness in the world. History jumps at us all at once; it does not crawl along a linear scale. History is like one big dip and another big climb after the other in no particular order. Up and down and down and up but never straight. The subjective certainty of religion has been one traditional way to deal with the uncertainty of the Black Swan.

The story of the American turkey and Thanksgiving is a good example of how the Black Swan theory works. For the first one thousand days of its existence, the turkey believes that the human race is more concerned about its health and well being than anything else in the world. But, then, when Thanksgiving rolls around the turkey realizes that all we were really concerned about was producing a fat and juicy meal for hundreds of thousands of American families. This loss of its life on day 1,001 was the Black Swan event for the turkey.

Before the first Thanksgiving, and based on historical data, all of the turkeys alive on day 1,000 would have thought they would be alive and eating well on day 1,001. This example demonstrates how hard it is to predict the future based on historical data. We have had many Black Swans in human history—events of limited probability but with great consequences. The events that may be predictable are those that arise in the micro sense but not those that occur in the macro sense. However, all of these events have a retrospective predictability that gives us an illusion of predictability.

The current financial meltdown has been described as something caused by an improbable series of events that could only happen once in a hundred years. This theory is based on the assumption that people are in fact in control. The illusion of control makes us believe that the Government and the Bush Administration are somehow in control of or know how to control the current financial mess. However, what really matters is not the probability of the event but the event itself and the measure of the event. The smaller the probability the more confident people are but the impact is just the opposite. The smaller the probability the lower the level is for a single error having a dramatic impact if and when the event occurs.

The inference that we can predict future markets and probabilities of small markets is not reliable. Probabilities are not like temperatures. We do not measure them. The properties are much too complicated to deal with complex problems. The problem with most theories is that the reverse is monstrous. For example, if you leave a small ice cube on the floor you can predict how it will melt. But, can you reverse engineer the water on the floor back into an ice cube? No, because you can have thousands of sizes and shapes for the new ice cube. There are infinite numbers of theories that can explain the size shape of the newly formed ice cube.

The United States of America is entering the most dangerous period of time since the American Revolution. The current banking system is a monstrous giant built on feet of clay. If the system fails, then all bets will be off. We live in world that is far too complicated for our old economic and financial structures. The continued consolidation of the banking functions tends to make one mistake ten times worse than if one small bank had made the same mistake. The current economic system is inherently turbulent but the tools and theories that have been developed to deal with them assume that one level of intervention can correct a systemic problem. The actions of the Federal Reserve Board and the Secretary of the Treasury in attempting to deal with the financial crisis are evidence that there are no “magic bullets” or simple intervention techniques that will solve the crisis. Historians will note that during the height of this crisis Bernanke and Paulson would come up with a new micro fix almost every day to remedy what was really a massive macro problem.

The network effect of globalization means that one shock in the system can have greater and far reaching consequences than it had during the pre-globalization era. The banks not lending to hedge funds will force hedge funds to sell off positions to raise funds. This action by the hedge funds will in turn drive down the prices of all similar positions. This lack of lending will lead to the inability of the local grocery store or hardware store to obtain financing for the purchase of inventory. This in turn will lead to the loss of more jobs and more homes which will affect a further downward spiral in all economic sectors.

So, what should we do? First, we need to spread the financial risk among as many banks as possible. The consolidation of financial power in a few major banks will lead to more not less random damage. Second, there is no one answer to the financial mess. The United States must employ a multi-dimensional approach that involves all aspects of the economy. Third, all of this will take time. Things will necessarily get much worse before they start to get better. Fourth, the new economy will be much different than the old consumer consumption economy

We must become more self-sufficient as a people and focus on new technology and industry and not on resurrecting the old oil and coal based methods of production. This is going to involve a lot of personal and corporate pain and suffering but there is no other way out. Our options are limited and we must pick the right ones. It is not a time to engage in predictions but rather a time to engage in affirmative actions.