Black Swans

by Larry Levin

Wall Street banks are like sausages: you just don't know what's in them. Case in point is Bear Stearns. At its peak it was worth about $35-billion. Last Friday it was worth about $3.5-billion, while this morning's net worth was down to about $250-million - or just $2-share.

Bear Stearns had been the 5th largest Wall Street bank and today it's gone. Poof! Did anyone see that coming? I doubt it; it was a Black Swan event.

A black swan is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. The Sept. 11th terrorist attacks are an example. Bear Stearns' crash and burn is another. The term black swan comes from the ancient Western conception that "all swans are white." In that context, a black swan was a metaphor for something that could not exist. That all changed, however, with the 17th Century discovery of black swans in Australia , which metamorphosed the term to suggest that the perceived impossibility actually came to pass.

"A similar effect is taking place in economic life. I spoke about globalization in Chapter 3; it is here, but it is not all for the good: it 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 now interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks (often Gaussianized [bell curve] in their risk measurement)- when one falls, they all fall.

"The increased concentration among banks seems to have the effect of making financial crisis 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...I shiver at the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. It means that we know less and less about the possibility of a crisis." -Nicholas Nassim Taleb, The Black Swan

Mr. Taleb's book was roundly criticized and ridiculed by the High Priests of finance on Wall Street...but Taleb is having the last laugh.

In his recent book - The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash - former banker Charles R. Morris explains the current dilemma:

"The question is whether the Countrywide's of the world are risk-taking enterprises or public utilities. You can't be both. If the government is going to be on the hook, by means of deposit insurance, the various federal borrowing windows, or implicit federal insurance for 'too important to fail' institutions, bank risk-taking has to be tightly controlled. Cautions, risk-adverse public utility-style banks need intelligent credit and balance-sheet managers, not envelope-pushing high-rollers with eight-figure paychecks."

Given today's state of affairs, I believe most taxpayers would prefer risk-adverse public utility-style banks with their balance-sheet managers instead of yesterday's high-flying MEGA-leveraged-bank. Many of the people I have spoken with regarding today's daily bail-out shockers would agree; you cannot have both. If the banks want to be "back-stopped" by the Fed, they must act differently and be willing to work under more regulations. In fact, their "willingness" is surely a moot point now: the government has shelled out so much money for this predicament that new regulations are guaranteed.

"Inflation is always and everywhere a monetary phenomenon." - Milton Friedman

Real Time Trading Signals*for

Trade Date: 3/17/08

E-Mini S&P Trades*
(before fees and commissions):

1) FT sell @ 9:15am at 1275.75 = +3.50 (1 lot)

2) VA sell @ 9:55am at 1285.25 = b/e (1 lot)

3) OTF buy @ 10:15am at 1274.50 = b/e (1 lot)

4) Engf sell @ 10:50am at 1273.00 = +4.25 (1 lot)

5) OTF sell @ 11:45am at 1267.25 = -.50 (1 lot)

6) FT sell @ 1:05pm at 1271.00 = -2.25 & -2.25

7) FT buy @ 1:25pm at 1269.50 = -.50 & -.50

8) TP sell @ 1:50pm at 1276.25 = -2.50 (1 lot)

9) FT buy @ 2:15pm at 1277.50 = b/e (1 lot)

10) VA buy @ 2:40pm at 1284.50 = +2.00 & +1.50...+2.75 points

E-Mini Russell Trades*
(before fees and commissions):

1) Sell @ 12:46pm at 649.6 = +1.6 (1 lot)

2) Buy @ 1:15pm at 650.0 = -1.3 (1 lot)...+$30


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