Fat Tails

"I should have stayed away from the stump."
Elizabeth Bonner

The figure in the distance was no native Nicaraguan. He was too pale. Too tall. And he was running towards us. People do not run in the tropics.

It was my son Jules. But Jules does not run often either. Was something wrong?

"Dad," Jules reported when he reached us, "Mom’s had an accident at the stable." In a second, there were three of us running along the beach.

People who ride horses suffer accidents all the time. Among the regular riders we know, few have not worn a cast or a neck brace on occasion. Riders are regularly kicked, thrown, knocked off or rolled upon. Riding competitions and fox hunts usually have a few people with gimpy legs or crutches in attendance.

Insurance companies can calculate the odds and set rates according to their risks. A man, raising himself into the saddle, might know that his chances of breaking his neck are 1 in 13,000 or that the odds of breaking a leg are 1 in 1,300.

But the statistical precision is an illusion. On the day a man is going to break his neck on horseback, the odds are 100% against him. Elizabeth is a good rider, I thought to myself as I ran along the beach, but so was Christopher Reeve.

Our stay in Nicaragua was blemished by only one scary event. I bring it up only to raise the subject of risk…and to leave you in suspense.

On September 23,1998 William J. McDonough, president of the N.Y Federal Reserve Bank, brought together the heads of America’s biggest banks – along with representatives of several large foreign banks. It was an unusual thing to do. In fact, it had never been done before. But the Fed feared the collapse of Long Term Capital Management might expose the banks to a level of ‘systemic risk’ that had never been seen before.

"Long Term knew it had to reduce its positions, but it couldn’t – not with the market under stress. Despite the ballyhooed growth in derivatives, there was no liquidity in credit markets. There never is when everyone wants out at the same time…"

"Thus," continues Roger Lowenstein’s account of the fall of Long Term Capital Management in 1998, "in September, 1998, traders were becoming acutely aware of risk. Spreads between ‘safe’ treasury bonds and less safe corporate or foreign bonds were spreading. In the crowded theatre of the bond trading, in particular, all the players seemed to come to the same conclusion at the same time. Rushing for the exits…they posed a danger not only to themselves, but to the entire world financial system.

"We refer to Lowenstein’s book, "When Genius Failed" again today because your editor just read it…and because he believes that genius never fails just once.

The geniuses at Long Term Capital Management managed to turn its silk purse into a sow’s ear in just 4 years. The losses to LTCM’s trading partners might have been even bigger. But the geniuses at the Fed and central bankers worldwide rushed to what central bankers generally rush to do – provide more credit. The generous helping of new credit provided by the Fed following the triple disasters of the late ’90s – the Asian currency crisis, the Russian bond collapse, and the fall of LTCM – was bound to produce some failure of its own.

"It was bizarre," said one trader as LTCM was losing billions. "Day after day we had massive losses, and they didn’t stop."

Lowenstein explains what happens at the end of a boom: "When losses mount, leveraged investors such as Long-Term are forced to sell, lest their losses overwhelm them. When a firm has to sell in a market without buyers, prices run to the extremes beyond the bell curve. To take just one example, yields on News Corporation bonds, which had recently been trading at 110 points over Treasury’s, bizarrely soared to 180 over, even though the company’s prospects had not changed one iota. In the long run, such a spread might seem absurd. But long-term thinking is a luxury not always available to the highly leveraged; they may not survive that long."

Lowenstein is describing what statisticians call a "fat tail." A bell curve ought to be perfect – as perfect as the Nobel Prize winners thought the market itself was. In fact, the market is not perfect in a mathematical sense or logical sense. It is only perfect in a moral sense; it gives people what they deserve.

At the extremes, prices no longer follow a logical pattern. Investors become irrationally exuberant when prices reach their peaks at one end of the curve…and desperately fearful at the other end. Very few stocks, for example, should ever be extremely expensive or extremely cheap. Normally, very few are either. But at the dark ends of the bell curve, fear and greed haunt the markets – and send prices running in unpredictable ways. Investors buy stocks at ludicrous prices at the top…and sell them at equally ludicrous prices at the bottom. The tails – on both sides of the bell curve – are fattened by absurdities.

But people are free to believe anything they want. And from time to time they almost all come to believe the same thing. In the mid-’90s, professors were winning Nobel Prizes for showing how markets were perfect and how risk-reward ratios could be quantified as though an investment were a throw of dice or an actuarial table.

When you throw the dice, the odds of any given outcome can be calculated. And they are always the same. Whether you get snake eyes one time or a hundred times, the odds of rolling snake eyes the next time are the same. Dice have no memory.

Investors do have memories but not much imagination. They shift the odds constantly, following their most recent experience. The period 1982-2000, for example, was marked by such generous stock market returns that investors came to expect them. Since then, the last two years have been losing ones. But investors still think stocks will revert to the mean return of the ’82-’02 period – about 18% per year.

Prices are a function of confidence. When investors are confident, prices rise. When they are not, prices fall. But confidence, too, is mean-reverting. It took 18 years of rising stock prices to bring investor confidence to present levels. It will take several years to beat it back down to the long-term mean. Neither most investors nor most Nobel Prize winners can imagine it, but the odds that the next 20 years will mimic the last 20 are vanishingly small.

When investors are spooked, Lowenstein explains, "capital naturally flows from riskier assets to less risky ones, irrespective of their underlying value." In a real pinch, no one wants the riskiest investments. Long-Term Capital Management had been so sure of its computer models and so eager to squeeze out every possible bit of profit that it found itself in possession of the riskiest bets in the marketplace. But these were not cheap stocks it held. It could not just hunker down and wait for the market to return to its senses. Instead, LTCM held derivative contracts and other investments that neither paid dividends nor had any intrinsic value. What’s more, thanks to its stellar reputation, it had been able to purchase its positions on nearly ‘no money down’ terms. At one point, for every $100 in exposure, the fund held only $1 in equity. As little as a 1% move in market prices – in the wrong direction – would wipe it out.

In the autumn of 1998, the market was moving in the wrong direction every day. A fat tail had been reached in credit markets – where all the traders seemed to want to get out of the very same positions at the very same time. The professors didn’t know what to make of it. It was "a kind of volatility they didn’t understand," said one of the LTCM partners.

The company was named Long-Term, but just 4 years after they opened for business their backs were up against a wall of prices they had said would not be likely in more than a billion years. Their mathematical models, Lowenstein claims, showed the odds of this kind of market were "so freakish as to be unlikely to occur even once over the entire life of the universe and even over numerous repetitions of the Universe."

"The professors hadn’t modeled this," writes Lowenstein. "They had programmed the market for a cold predictability that it never had; they had forgotten the predatory acquisitive, and overwhelmingly protective instincts that govern real-life traders. They had forgotten the human factor."

They were right about regression to the mean. Things that are extremely out-of-whack eventually work their way back into whack. But then they diverge again and the tails fatten. Sometimes prices diverge from the mean. Sometimes they regress towards it. Give yourself enough leverage and you can go broke in either direction. The geniuses at LTCM lost $4.5 billion – much of it their own money. You or I could probably never have lost any where near that much – even with a computer, we’re not that smart.

The banks lost money too. They would have lost a lot more had they not come to the aid of LTCM…and the central bank not come to the aid of everyone by providing more credit. This new burst of credit was
taken up by a new group of geniuses – such as those at Enron. Compared to Enron, LTCM was "like a lemonade stand," Frank Partnoy told a congressional committee. Enron earned more in derivatives trading in a single year than LTCM did in its entire existence.

The N.Y. Fed helped save the world from LTCM, but it set investors up for Enron…which cost them 16 times as much.

Your humble editor,

Bill Bonner
March 4, 2002 — Nicaraga

P.S. Elizabeth was already hobbling into the clubhouse, supported by Manuel, by the time I got there. Her horse had tripped on a stump and fell over on her. What a relief – to find her ambulatory with no bones sticking out in odd places! She was back on a horse the next day.

P.P.S. Neither the geniuses at LTCM or at Enron are still geniuses. Both have failed. But the entertainment is not over. We still have the geniuses at the Fed and far more ‘systemic risk.’ And plenty of stumps.

We rouse ourselves, reluctantly, from the dream of Nicaragua – with its long walks on wide, sandy beaches. and drowsy afternoons in shady hammocks – and face the newspapers and internet once again.

Eager to catch up on 3 weeks of news, I scanned the front pages of the International Herald Tribune. What has happened to the recession. Osama bin Laden…Enron? I rubbed my eyes and wondered.

No mention of bin Laden. He seems to have moved and left no forwarding address. Enron is still in the news, but the story has been moved from the financial pages to the people pages. as if the Skilling-Fastnow-Lay trio were members of a rock band that just broke up. And the recession?

"U.S. slump proved to be short-lived," says Friday’s headline. Revised figures show the economy grew at a 1.4% rate in the last quarter of last year. "The new figures indicate that economic activity contracted only in the third quarter of last year," continues the report. If the new numbers resist further crunching, this will be the shortest recession ever.

The nation’s factories have been reducing output since July of 2000 – the longest slump since the Great Depression – but consumers took no more notice of the recession than morning commuters of a traffic accident. They just kept on trucking, increasing spending by 6% throughout the downturn.

War, recession, financial chicanery… apparently all is forgiven or forgotten.

The critical question for readers is this: Does 2002 mark the end of the bear market and recession, as everyone believes – or just the beginning? As usual, we will take the uncrowded side of this trade – betting that the slump has barely begun.

Eric, how did Wall Street take Friday’s news?


Eric Fry in New York:

– Mr. Market "busts a move!"

– The Dow Jones Industrial Average soared a whopping 262.73 points to 10,368.86, while the Nasdaq Composite raced ahead 4.1% to 1,802.75. The rest on the week wasn’t too shabby either. The Dow and the S&P 500 both surged 4%, while the Nasdaq jumped 4.5%.

– While no one can say for certain what caused this spontaneous eruption of bullishness, Friday’s report from the Institute of Supply Management (ISM) seems as good a reason as any. The ISM’s index of manufacturing activity jumped to 54.7 in February from 49.9 in January. The strong February reading marks an end to 18 consecutive months of contracting manufacturing activity, and the stock market loved it.

– The rally arrived not a moment too soon. "Even the world’s richest people feel the sting of a depressed economy and shrinking stock portfolios," the Associated Press reports. "The world’s distinct club of billionaires dropped 83 members this year to 497 as recession and fallout from the terrorist attacks reduced their wealth." For the second year in a row, the bear market in stocks thinned the ranks of billionaires. Among those dropping from the group this year was AOL Time Warner Inc. (AOL) Chairman Steve Case, whose stock has been almost cut in half over the last 12 months.

– Get out your hankies. "Microsoft Corp. (MSFT) co-founder Bill Gates lost $6 billion last year, but that didn’t stop him from being the richest man in the world for the 8th year in a row," says the AP. "With a net worth of $52.8 billion, he remained comfortably ahead of Warren Buffett, who held the No. 2 spot with $35 billion."

– So there you have it, Gates and Buffett continue to run 1-2 in the billionaires’ club. Some things never change.

– Indeed, the same could be said about the players who influence the financial markets. Post-Enron, Wall Street may have changed much less than most folks would like to believe. How do public companies comport themselves in this new era of corporate transparency and forthrightness? Pretty much like they did in the old era of dissembling and cozy relationships with Wall Street. Consider the following little story about the ad agency Interpublic Group.

– "The Interpublic Group of Companies, Inc., is the largest organization of advertising agencies and marketing services companies in the world," the company’s Web site boasts. Indeed, IPG’s marketing prowess is perhaps nowhere more evident than in the presentation of its feeble financial results.

– Last Thursday evening, when the company released its fourth quarter earnings, which included neither a balance sheet nor a cash flow statement. In the event, it was impossible to determine the company’s operating cash flow. Furthermore, when an analyst asked about operating cash flow on the conference call, the company ducked the question. No other analyst on the call even broached the subject.

– Despite the critical omission of a balance sheet and a cash flow statement, no less than four brokerage house analysts rushed out research reports the following morning, rating the stock some version of "buy."

– IPG’s sparse disclosure suited their purposes just fine. Thanks to all these analytical "high fives", IPG shares soared 14% on Friday.

– Only Lehman Brothers dared to observe, "We did not see or hear anything in this [quarterly] report to get us more excited at this point," while maintaining a luke-warm "Market Perform" rating on the stock.

– But elsewhere on the Street, analysts were effusive. "Brightening Outlook and Strong Free Cash Flow Trump Weak Revenue," gushed JP Morgan analyst Fred Searby.

– This free cash flow comment so puzzled Grant’s Investor analyst, Robert Tracy, that he rang up Searby to find out how the man calculated free cash flow with neither a balance sheet nor a cash flow statement.

– Searby proceeded to berate and belittle Tracy. The Morgan analyst was clearly irked by the implication that he ought not to make definitive cash-flow comments in the headline of a "buy" recommendation without having seen the actual supporting documentation.

– Why wouldn’t Searby want to engage in a truth-seeking discussion, you may wonder? The answer may be contained in the disclosure at the end of his report, which states that "J. P. Morgan Securities Inc. and/or its affiliates acted as lead or co-manager in an offering of securities for Interpublic Group and WorldCom Group [an IPG subsidiary] within the last three years."

– In other words, any critical comment about the company by Searby would be a very good way for Morgan to lose IPG’s lucrative investment banking business.

– Welcome to the post-Enron era of "transparent" and "forthcoming" corporate management, monitored ever-so- vigilantly by the conflict-free Wall Street analyst.


Back in Paris…

*** After spending 10 days in the tropics, returning to France was a shock. The heat in the house had been off for three weeks – and would not come back on. We made fires in two of the fireplaces…huddled around…and wished we were back in Nicaragua.

*** How’s Nicaragua doing? Pretty well. Daniel Ortega, former Sandinista dictator, ran in last November’s elections as a born-again Democrat. He lost, decisively. Even more encouraging, graffiti artists are beginning to deface his campaign posters…

*** The country is still a third-world hell-hole, of course. But it’s getting better…and worse. Huge, new shopping malls are packed. The streets are filling up with cars. A paved road seems to be working its way towards our property on the Pacific coast.

*** What’s nice about the place is that the countryside is beautiful, the people are pleasant – and you can make your own little paradise out of it. A cook or gardener, for example, will work all day for only $5. And you can find places of such stunning beauty – along the coast or on one of the lakes, for example – that you won’t want to leave.