Sunday, May 18, 2008

Black Swan or Six Sigma Event?

A black swan event, loosely described, is an occurrence that: 1) is structurally possible within a system, 2) is of very low probability within that system, but which 3) should it take place has a disproportionate impact upon the systemic order. Does the present financial crisis as a whole represent a low-probability nonlinear transformation of the US or the global financial system, or of major markets therein? In my view, no---or at least, not yet.

The financial community does not use the black swan terminology, but the claim is the same: "Our crisis was not foreseeable." "The system is liquid, it's just in a stubborn panic." "We are the victims of fraud and a lack of transparency; wider remedies would be unhelpful." "Financial innovations are sound, and they did not contribute to unanticipated market instabilities." We have 'an accident' where no one at the scene claims to be or know the driver.

On present examination neither the bubble nor its crash fit the black swan hypothesis. Many if not most of the component processes of both were linear, highly probable, and fully visible.

Mortgages increasingly came to be originated to borrowers at the bottom of the financial system whose capacity to pay depended upon the continuation for decades of historically very low interest rates; similarly, hundreds of billions of dollars were lent for securitized junk bond debt speculation at the top of the financial system where the viability of that debt also depended upon the continuation of historically low interest rates; concurrently with these entirely observable trajectories, bank-like speculative vehicles proliferated which borrowed, lent, and underwrote the quasi-insurance of credit default swaps to very large sums, again facilitated by historically low interest rates and by borrowing at the extreme short term via commercial paper offerings to capture the best rate spreads. No commercial bank was then permitted to operate with the severe leverage, lack of hard reserves, and term mismatches of these 'wildcat banks,' to resort to an historical term, since these practices, severally and jointly, have a strong association with financial failure.

If, when, and as rates rose, large portions of these debts would turn sour. If these debts went sour, the value of the securitized loans as collateral would decline. If the value of the collateral declined, the terms for short term loan refinancing would shift higher in rates and requirements even if liquidity remained constant. These were linear relationships of high probability.

By the autumn of 06, both residential real estate prices and residential mortgage failures had diverged so extremely from long-term trends that if these shifts were sustained the changes themselves would have represented a nonlinear systemic transformation. Instead, the observable linear relationships held: mortgage delinquencies rose and home prices flattened as interest rates rose, maintaining their historical correlations if at extreme values: not New and Different but More of the Same only more so.

A drop of 300 basis points in interest rates did not reinflate the mortgage, junk bond, or commercial paper markets since accelerating housing price declines at the bottom of the financial system and major unrealized losses at the top of the financial system served as ironbound negative indicators for loan risk.

If the exact circumstances for the implosion of Bear Stearns in March remain opaque, it is clear that they faced a major run of customers, cascade of margin calls, and withdrawal of dealer counterparties: a very large if old-fashioned bank run performed by financiers rather than retail depositors. There has yet to be any mention of a precipitating major loss for BSC from a nonlinear event. All of these events, and likely more to come, are directly driven by linear price declines in massive quantities of securitized debt, trajectories which were largely locked in from the date of issuance for these instruments.

The surge and purge of the Securitization Bubble has not been a black swan event; it has been a cooked goose event. In that respect as in prior historical examples, the faces change but the fools remain the same. A salient hypothesis from this summary, to which I'll return, is that to the extent that nonlinear processes figured in these trajectories, they were in the making of the bubble more than in the baking of it. The 'black swan' metaphor fails 2), its low probability condition. In fact, we have not even seen 3), a real shift in systemic order in the financial system---yet.

Despite well-publicized failures of some exposed small and mid-size operators, there has been no default cascade to this point, either of short-term obligations of securitized debt holders or swap counterparties. Few banks or bank-like entities have failed outright, though only due to massive public lending. Over the counter securitized debt transactions can and do take place, though they have become rare. Liquidity is in the system for mundane commercial loans, though money is far more expensive. Mortgages are still issued, though far fewer and none at all for higher valuations; the volume declines are linear expressions, however. Local government revenues are declining, but service collapse, bond defaults, and bankruptcies are not widespread. Yet; not yet. And so long as price declines for securitized assets are not realized faster than asset holders acquire offsetting capital, such outright market failures may not happen at all.

Those asset price decline trends?: they appear to be accelerating, and have a long way to run; a long way in relation to historical prices; a long way in relation to inventories; a long way in relation to solvency. We haven't seen truly non-linear changes in the financial system---yet, i.e. (sustained) turbulence, catastrophic order transformation (say of market volume, market participants, or currency), or chaos.