Legal Commentary

I?m reading The Black Swan by Nassim Nicholas Taleb (I know it?s been out for a while ? I?m behind), and I had a thought about the current credit crisis caused by the housing downturn.  Is the financial crisis a ?black swan??

Taleb defines a ?black swan? as follows:
?First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.?

For what it?s worth, Taleb would call this event a black swan ? as discussed here.  In fact, I think he already has called it one.  There is likely little dispute about the large impact of the crisis (though history will tell for sure), so I want to focus on whether the crisis really ?lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.?  I?ll address after the fact explanations later. 

I?m not quite convinced that this event is an outlier.  My reasoning is after the jump.

Even if, for example, the housing bubble was a black swan, the bursting of the bubble should not have been an outlier. After all, bubbles burst.

Sure, the housing market drop that precipitated the drop in value of mortgage backed securities was unlikely.  I would argue, however, the problems were not unforeseeable and certainly not outside the realm of regular expectations.  The point of bundling mortgages into securities diversified two types of risk.  First, it diversified the risk that individual mortgage holders (homeowners) would default ? if one of many default, the securities would still have value.  Second, it diversified against the risk that housing prices would drop in a particular geographic area, causing systematic defaults in that area ? the securities were diversified by geography as well.

They did not diversify against systematic default nationwide, however. They also did not diversify risk in a portfolio that was heavy on these types of securities vis a vis other types of securities.  Thus, it was completely foreseeable that if housing prices dropped nationwide, then these securities would lose value across the board, causing a reduction in value of the portfolios in which they were held.  While short-sighted, it was not outside the bounds of human experience that housing prices might drop nationwide ? at least I would argue that it is not.  If this is the metric, then the crisis wouldn?t qualify as a black swan, no matter how impactful it may end up being.

Of course, Taleb makes clear that the black swan is point of view specific.  Thus, one could argue that it is a black swan for those who were shortsighted, but not for those who were smart enough to predict that bad things would happen.  After all, Taleb stated in his book that massive failure due to ?interlocking fragility? will be black swans.  Even limiting the black swan to a point of view, I think that something like this crisis was within the realm of reason for anyone who has a basic understanding of systematic risk.  Perhaps this is based on my incredulity and disappointment that so few with the ability to do something could see this coming, but ignorance should not make an event something outside the bounds of regular expectations.  One of my oldest clients has made  career of teaching oil companies, banks and others about how to manage systematic risk and low probability events through the use of monte carlo simulation.   One of his best clients is a well known bank that has escaped this debacle apparently unscathed.

Of course, there is a contrary argument.  While a systematic rise in defaults might have been foreseeable, the confluence of factors that led to this particular crisis at this particular moment might not have been:

• The growth of the subprime market and its associated problems
• The concurrent decrease in interest rates for everyone else
• Too much investment in these securities by so many institutions
• Too little consideration of the foreseeable risk of default
• The interaction of mark to market and capital to lending ratios
• Insert your favorite regulatory failure here
• Other problems in the economy

True, one would expect a couple companies to pay the price for non-diversified risky investing, but I have not heard anyone describe a time in our history when all (or even most) of the above factors interacted in the way they have here.  I suspect Taleb would say that this is just the third factor ? attempting to explain the event after the fact in a manner that makes it seem like it should have been predictable.  Perhaps the answer lies in whether one expected  something to happen, even if one did not know what or when or how big.  I guess I'll have to keep reading to find out how much detail one needs to classify an event as a black swan.