Fat Tails

Bonner on the day that genius failed; an inspiration for the second chapter of Financial Reckoning Day. This essay was originally broadcast on 4 March 2002.

"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 foxhunts 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.

When Genius Failed: September 23, 1998

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 theater of 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," today because your editor just read it…and because he believes that genius never fails just once.

When Genius Failed: Silk Purse to Sow’s Ear

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 do 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.

When Genius Failed: How the Markets Were Perfect

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 the 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.

When Genius Failed: Forgetting the Human Factor

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 anywhere 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

October 08, 2003 —  Nicaragua

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.

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the Wall Street Journal and NY Times bestseller: "Financial Reckoning Day: Surviving The Soft Depression of The 21st Century" (John Wiley & Sons).

Yesterday brought good news to those who would like to see the country ruined.

First, stocks continued to rise on Wall Street.

Second, it was reported that consumers continued to scrape their way towards insolvency throughout the summer. Borrowings increased by $8.2 billion in August, with consumer credit rising at a 10.25% rate.

Third, the NY Times reports that the "Dollar weakens again," adding the cheerful instant analysis: "No U.S. tears shed."

This last remark may need qualification. When the dollar goes down, Americans have less purchasing power. Since so much of what they buy comes from overseas, a serious drop in the greenback would cause prices to rise and reduce standards of living. Another way to look at it is that a fall in the dollar reduces the value of everything made in America and every asset calibrated in U.S. currency. Even a 10% decrease would be the equivalent of reducing the value of U.S. output by more than a trillion dollars, for example.

This may not be cause for tears, but an alert investor might at least get a little misty-eyed. Likewise, the California homeowner might be a little disappointed to realize that the ‘equity’ he borrowed out of his house disappeared in the currency markets…while he still has to pay off the loan or lose his house.

Of course, those of us who live overseas and pay our bills in Europe feel the greenback’s slippage more immediately and take it more personally. We are annoyed by it every time we order a glass of beer or tuck into a canard à l’orange. There is no point in complaining about it, but we can’t but wonder how long it will take for other Americans to realize that a falling dollar makes them poorer, too.

But no tears were shed yesterday, according to the NY Times. People imagine that the dollar will do a graceful dive…and thereby put the world economy back in balance. Then, they believe, the recovery can fully express itself and the real boom can begin.

The people who think this are the same people who are not only delighted that consumers keep digging deeper holes for themselves…they egg them on! And they are the same people who think that stocks can go up forever…or at least until after the next election.

Elsewhere in yesterday’s news, it was reported that the Carrier Corporation, which brought affordable air conditioning to millions of Americans, announced that it was ceasing all U.S. manufacturing. Henceforth, all new Carrier machines will be imported from overseas. Twelve hundred employees are now sweating out a new job search.

A lower dollar is supposed to help companies like Carrier. Maybe it will. And surely a decline in the dollar is necessary… and inevitable. But it won’t come without tears.

More news from Addison, below…

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Addison Wiggin at the Daily Reckoning HQ in Paris…

– Well, at least they appear to be keeping track, even if they’re not at all concerned. The Fed, that is. It was a Fed report, released yesterday, which informed us that Americans had piled on $8.2 billion dollars in credit in August. The annualized figure is $1.95 trillion and change.

– Okay, let’s do the math. According to the World Fact Book, the GDP of the entire U.S. economy is just over $10 trillion – that’s $37,600 for every man, woman and scamp in the country – making it "the largest and most technologically powerful economy in the world."

– What really goes on in the "largest and most technologically powerful economy in the world"? Well, a whole lot of borrowing for consumption, apparently. Apart from the fact that 80% of that U.S. GDP is derived from ‘services,’ on an annualized basis, in the month of August, the Almighty American consumer borrowed nearly 20% of the world’s largest economy’s GDP.

– What’s more, as we reported in these pages last week, the average household carries an outstanding credit card debt load in excess of $8,000. Reaching for the calculator once again, we see that the average household is funding nearly 20% of the per-capita GDP with consumer credit.

– As if that’s not interesting enough…we scan down the World Fact Book page a little to look at the revenues for the U.S. government in 2002: $1.94 trillion! If consumers continued to rack up debt at the rate they did in August for an entire year – they would borrow more money than all the tax receipts of the federal government combined. (The government, of course, spent more than $2.02 trillion in 2002, but what else would you expect from those clowns?)

– "How long can this all go on?" We ask with the droning repetition of a floor sander. Of course, the reply, for some, must of necessity be: "as long as possible."

– The Fed themselves might utter just such a response. According to the Mogambo Guru, who makes a habit of tracking these things, last week, "the Fed jumped into the money-mobile, turned on the ignition, put the Fed into high gear and roared back into the market. Greenspan goosed total credit by $9.5 billion…a new record. Foreign central banks decided they would be happy to soak up the debt of an almost-bankrupt nation of fat deadbeats, and took up another $10 billion…also a new record."

– Debt. Consumer debt. Treasury debt. Corporate debt. All is debt. Debt. Debt. Debt. Debt. Debt. Who will pay for all the debt? And with what quality of currency? One begins to see the wisdom of the Fed’s "War on Deflation"; deflation makes debt more costly to repay. Inflation, on the other hand, is a debtor’s best friend. If you happen to be a saver…tough luck, pal.

– Mr. Market, for his part, who makes a habit of ignoring these things, jumped…the Dow climbed 59 points to 9,654…the Nasdaq leaped 14 to 1,907…and the S&P slithered nearly 5 points up to 1,039. But who cares? According to one study, the stock market is but a boil on the peau of American families’ balance sheets.

– Providian Financial Corp., a company that specializes in debt, bad debt, and worse debt, released findings yesterday showing that during the boom from 1995 to 2001, the net wealth of the typical middle-class household rose 23% from $60,000 to $74,000. But "while stock holdings grew," summarizes the AP, "stocks still represent a minor portion of net wealth" for the typical middle-class family. What really seems to comprise their wealth is debt…and consumption.

– One of the more inane explanations we’ve read recently explaining the rally in the stock markets and the so-called ‘recovery’ (jobless as it may have been) came by way of an editorial in TheStreet.com, written by a writer on whose behalf we would be ashamed if we were to mention his name, so we won’t. His theory was that "wealth" – at least, as it’s understood in the context of the late degenerate capitalist model – can be quantified and expressed by a family’s power to consume.

– Under such a scenario, debt = wealth. Again, let’s do the math. If we were to carry $8,000 in credit card debt…we would be able to add $8,000 dollars to our personal net worth. The nation, by August standards, would likewise be able to add an additional $1.95 trillion to the national GDP. This is the kind of thinking that leads to headlines lauding economic recovery and the rebirth of the bull market boom.

– We here at the Daily Reckoning HQ are left with only one question: Where do these people come from?

– Some 50% of the 1,000 people who responded to the Providian survey said they were "worried" or "very worried" about their family’s finances. To their credit, the conclusion of the Providian Financial report was that in order to avert feelings of worriedness, Americans need to save more…(Duh…)

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Bill Bonner, reposing in Nicaragua…

*** Thank God for the Carrier Corporation. Your editor spent much of yesterday hiking over the green hills, sweating. Had it not been for air conditioning, some of the most beautiful areas of the planet would be scarcely habitable.

*** Well, now it is official. The weight-lifter has been elected governor of the Base Metal State. He takes his place at the head of the world’s fifth-largest economy. At least, it is now.

The Austrian’s name can now be added to a distinguished list of America’s greatest politicians. It is sad to see a good man gone bad like that.