2008-12-10 10:25:00By Justice LitleLast week I caught a great Nassim Nicholas Taleb interview on the Charlie Rose show. Taleb is one of my favorite writers. He is known for being a pretty cranky guy in person – you don’t want to get on his bad side in a conversation – but his insights are first-class.Taleb’s most recent book, The Black Swan: The Impact of the Highly Improbable, is one of the most thoughtful and entertaining reads I’ve had in years. In his most recent sitdown with Charlie Rose, Taleb put forth a number of intriguing ideas as to what’s next for the financial system.I took a few pages worth of notes – what follows are excerpts of those notes plus follow-on commentary. The italics are either direct quotes from Taleb or my paraphrasing of his thoughts.Why Bankers are Turkeys“The turkey is fed for a thousand days by a butcher. And every day confirms to the turkey – and the turkey's economics department, and the turkey's risk management department, and the turkey's analytical department – that the butcher loves turkeys. And every day brings more confidence... On the day when the turkey's comfort is at its maximum, it's going to be a surprise.”The Thanksgiving turkey analogy highlights an important truth. Past performance does not always guarantee future results!The turkeys, in this case, are the bankers. They thought that subprime would never blow up... that home prices would never go down... that the days of thirty- and forty-to-one leverage could go on forever.Two deadly factors that led to the blowup of the system were complacency and complexity – or rather, complacency in the face of mounting complexity. Things just started getting woolier and woolier but no one cared – or at least very few people cared – because the banks were all making money.It’s interesting too that the “quants” – the rocket scientists of Wall Street – made the same basic mistake as Taleb’s turkey.All the quant’s fancy formulas were based on an incomplete data set. They didn’t extend their analysis far enough into the past to see that turkeys get slaughtered every 1,000 days. Instead, they only looked back the equivalent of 900 days... and assumed the butcher would never turn on them.A key point of Taleb’s is that some risks can’t be accounted for. People seem bound and determined to get this wrong. When the typical Wall Streeter hears about the Black Swan – Taleb’s shorthand for a powerful unexpected event – the question is always, “How do we spot the next Black Swan?” But the whole point is that you can’t predict them in advance.Here comes Capitalism IIWhat will “Capitalism II” look like?Capitalism II is Taleb’s phrase (at least I assume it’s his) for what will come next... how the global landscape will appear after the rubble and debris of 2008 has been cleared away.Banks will converge with the model of utility companies... no more socialization of risk. If the public is to bear bank losses, we won't tolerate fueling their bonuses for 5-7 years before bailing them out.This makes perfect sense. Why were banks allowed to take on 40-to-1 leverage in the first place? That’s enough to make the most hardened futures trader blanch.As a general free market rule of thumb, businesses should be allowed to take on risk as they see fit... but the banks have long been tinged with a public hue. Through programs like FDIC insurance, political support of mortgage lending and other implied federal gurantees, the banks have benefited heavily from a sort of creeping socialization of risk.So if the banks are going to get a visible helping hand from the public, they should also be reined in by the public.And would the public stand idly by if, say, a utility company started taking crazy risks with nuclear power plants in order to provide bigger payouts to shareholders? Of course not. The comparison between banks and utilities is a good one, considering how Citi looks like Three Mile Island right about now.The Problem With “Too Big to Fail”We’re going to see massive deleveraging... banks will have an entirely different class of risk-taking, under condition of no societal bailouts... less debt, fewer debt investments, more asymmetric investment in upside... getting rid of these players who have almost no downside risk via socialization of their mistakes.Basically we have to get back to the place where “too big to fail” no longer exists... where no single entity (or group of entities) is so loaded up with risk that the blowback from their failure threatens systemic failure on the whole.We can see this with the recent news of laid-off workers occupying a factory in Chicago.The Republic Windows and Doors company had to shut down a plant after Bank of America killed the company’s credit line. The workers at the plant, told they might not even be paid for work already done (let alone keep their jobs), decided it was just too much for Bank of America to get a $25 billion check from Uncle Sam – money that was supposed to go to lending – while their lives were being destroyed for lack of a credit line.We don’t yet know the full details as to why the plant had to close. But the root of the problem, plain as day for all to see, is that the banks were allowed to take foolhardy risks... and then got propped up with taxpayer funds rather than being forced to pay for their mistakes.When a normal business fails and unprotected workers get fired, there is no bailout. The way to get rid of the double standard is to force banks to live within their means. If that forces them to become the most boring institutions on earth (utilities again), so be it.No More Blind WorshipMarkets are not smart, they are stupid and can be fooled by gaming the numbers... evidence shows markets are horrible at predicting rare events.Charlie Rose flinched when Taleb forcefully used the word “stupid” to describe markets. In recapping Taleb’s assertion, Rose worked hard to avoid the “S” word himself. Such an insult to all the pointy-headed academics with dispensation from on high!I think Taleb is 100% right about markets being stupid and foolable – at least some of the time. Mr. Market, if you will, is a very intelligent guy prone to bouts of extreme irrationality.It is possible to believe (as I do) that markets are mostly efficient... that markets are mostly good at price discovery and uncovering the rough intrinsic value of things... while still leaving room for the fact that markets can occasionally veer way, way, way off course.(After all, don’t human beings function exactly the same way? Who among us doesn’t break their standard “calm and rational” stance with a bout of pure loopyheadedness every once in a blue moon?)I have great respect (as I suspect Taleb does too) for the value of ideas – including the ground-breaking ideas of neoclassical economic theory.Part of the trouble, I think, is that we as humans have an inborn tendency to worship too much – to hold up our ideas as perfect, instead of staying skeptical and keeping a sense of humor at all times.So what’s happening right now (in my view) is a cleansing of sorts... after decades of dogma preaching that markets are perfect and the experts from high know exactly what they are doing, we are now getting a long overdue frying pan to the face.In recognizing that markets are NOT perfect... that most so-called experts DON’T know what they are doing... we can go back over the books, reexamine what we believe about how free markets should function, and better sort the wheat from the chaff with a critical eye.More Pain and Selling?"Capitalism II" will create a society whose functions are more independent from asset value... to get there we'll need a lot more pain and selling.Agree and disagree there... it clearly makes sense to move to a society “more independent from asset value.”In plain English, that just means the real economy will be less affected by ups and downs in the price of things because so much of the leverage will have been wrung out. Those who continue to use leverage will do so responsibly, at their own risk and their own expense. We’ll be poorer but wiser for a time... and eventually we’ll be wealthier again.As for needing a lot more pain and selling – the operative question there is, how much is enough?Wall Street has basically been vaporized. Hedge funds have been shoveling assets out the door as fast as they can ever since mid-September (when Lehman blew up). Stocks in multiple industries, from retail to energy to base metal mining, have seen price declines exceeding 80%.I’m skeptical of those who say “more pain is coming” in a macro sense without taking account of the bottom-up picture. It’s one thing to expect more pain as part of the natural order of things. It’s another to look around and see how valuations have not only seemed to hit rock bottom in many areas, but been drilled into bedrock.Tomorrow we’ll talk a little more about valuations and recent market action. I’ll also share some insights and ideas that came in from you, the readers, regarding last week’s commentary on saving and spending.
