In the year 2003 or thereafter
The fault confused within the rest
Cygnus atratus shall descend from the sky
And the fan, he may hit the shit

Not everything Nassim N. Taleb says is rubbish. For someone writing about so many different things (people call him ‘eclectic’, although he prefers to be called a thinker), it would be quite a feat never to say anything interesting. His criticism of financial forecasters is undoubtedly warranted – for the most part. He’s also right in observing that forecasters have a bad habit of finding silly excuses for their misses, and tend to take credit for predictions they haven’t actually made (e.g. hindsight bias). But when I read Taleb, I’m constantly reminded of the pot that called the kettle a swan (or something).

One of Taleb’s achievements that boosted his popularity is his correct prediction of the financial crisis. Or should I say, his claim that he correctly predicted the crisis, or one particular event that occurred during the crisis. That claim is not only made by himself and his fans, but to my surprise, it is also admitted by some of his critics.

Before we have a closer look at the precise ‘prediction’ he’s credited with, let’s read again this passage by the master himself (The Black Swan – NN Taleb, 2010 (2^nd edition), pp 153-154):

I have avoided the press for a long time because whenever journalists hear my Black Swan story, they ask me to give them a list of future impacting events. They want me to be predictive of these Black Swans. Strangely, my book Fooled By Randomness, published a week before September 11, 2001, had a discussion of the possibility of a plane crashing into my office building. So I was naturally asked to show “how I predicted the event.” I didn’t predict it – it was a chance occurrence. I am not playing oracle! I even recently got an e-mail asking me to list the next ten Black Swans. Most fail to get my point about the error of specificity, the narrative fallacy, and the idea of prediction.

I get your point, Nassim: the example of a plane crashing into your office building was one of many others in your book, none of them meant as a prediction of something imminent. A Black Swan is unpredictable, by your own definition. Good of you to point that out, and also nice of you to refuse credit for a mere fluke.

The wise master turns out to be a terrible student though. In a 2008 interview, he made the interviewer read aloud a footnote from The Black Swan (TBS), apparently prompted by nothing else but the sight of a copy of his book in the interviewer’s hands:

[…] the government-sponsored institution Fanny Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry, their large staff of scientists deem these events “unlikely”. (TBS, pp 225-226)

The rest is history: a plane crashed into his office building. In the fall of 2008, after plunging stock prices and amid growing fears of an imminent bankruptcy, the US federal government placed Fannie Mae along with her cousin Freddie Mac in conservatorship. In less euphemistic terms: the two privately owned but government-sponsored entities (GSEs) were bailed out, with the cost to taxpayers measuring in the hundreds of billions of dollars. Quite an impressive prediction Taleb made, wouldn’t you say?

No I would not. And not just because I gladly heed Taleb’s own warnings about the error of specificity and the narrative fallacy. It’s the specific details of the circumstances that led to Fanny Mae’s fall, and the specific details of his comment (compared to those made by other critics) that are not awe-inspiring. To anyone who’d been reading financial newspapers since at least a few years before the crisis, Taleb’s warning was just one of the many (and certainly not the first) in a long list of controversies, reports of malpractices, and criticisms by economists, stock analysts and financial reporters.

A brief summary:

Initially established by the US government to create a liquid secondary mortgage market (by buying mortgages from local banks, allowing these banks to re-use the funds for new loans to other home buyers), Fannie Mae and the later established Freddie Mac were increasingly important in the federal government’s aim to spur home ownership. Their increasing importance (and size) paralleled a gradual relaxation of credit standards. Until the 1970s, Fannie Mae bought only government guaranteed and insured mortgage loans. Then Congress established Freddie Mac and allowed both GSEs to purchase uninsured mortgages as well.

The Housing and Community Development Act of 1992 mandated the GSEs to meet affordable housing goals, to ‘facilitate the financing of affordable housing for low- and moderate-income families’. The Clinton administration urged Fannie Mae to channel more funds into distressed cities. By the end of the 20^th century, the two companies were voracious buyers of subprime mortgages. A NY Times article warned in 1999 that ‘Fannie Mae is taking on significantly more risk’, and hinted at the possibility of a government rescue in an economic downturn.

In light of the fact that both GSEs carried similar risks, and both had to bailed out in 2008, why did Taleb mention only Fannie Mae in his famous footnote, and not Freddie Mac? As Taleb explains in the aforementioned interview:

I saw their positions in 2003, when a very smart journalist, Alex Berenson of the New York Times, came to me and said, Can I show you the risk of Fannie Mae?

Berenson recorded Taleb’s comments in another NY Times article: ‘Fannie Mae’s Loss Risk Is Larger, Computer Models Show’. The revealing computer models were not Taleb’s, but Fannie Mae’s own models:

Fannie Mae, the giant mortgage finance company, faces much bigger losses from interest rate swings than it has publicly disclosed, according to computer models used by the company to estimate the value of its assets and debts

Not publicly disclosed, the models were ‘provided to The Times by a former Fannie Mae employee, in return for assurance that he not be identified’. As Berenson points out in his introduction,

[…]some investors and outside experts say the company has become dangerously large and highly leveraged, with too much debt […]

And that was exactly what the models confirmed. This looks like a classic example of a company getting itself into trouble, privately aware of the risks it is facing, but issuing public statements that ‘there is no reason for anybody to be worried about the company’. Let’s take stock for a moment:

1. Investors and outside experts had already repeatedly warned about the big threats the GSEs posed to the financial system.
2. A whistleblower previously employed at Fannie Mae contacted a NY Times reporter, who in turn contacted Taleb, asking him to confirm if the models indeed revealed uncomfortable risk levels.

Now ask yourself, how much effort did it take Taleb to ‘look at’ the models? It seems ‘to look at’ should be taken literally here: he just had to read the conclusions, or look at the bottom line numbers. And how audacious or contrarian was his view that ‘[they] seem to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup’ in light of all this? Perhaps the footnote in TBS should be rewritten as follows:

The government-sponsored institution Fanny Mae, when I DON’T look at their risks but simply swallow the conclusions that have been carefully prepared, cut and spoon-fed to me; and when I spit them back out, of course not without adding some of my own bile for more flavor and a personal touch, …

That’s almost as impressive as predicting that it will rain tomorrow after reading the weather report.

Incidentally there’s something highly amusing about the article. It concludes by quoting Taleb, in his characteristic blunt style:

All these models are pseudoscience to me, […] there is no science in it.

Well then, Mr. Taleb, why did you unquestioningly accept the model’s conclusions when they were presented to you? Or did you base your judgment on something else; such as your banal comments in the same article that:

[…]the simulations are not exact, because Fannie Mae can never exactly estimate all the factors that will affect its portfolio, or exactly how rates may change[…] (emphasis added)

And, even more banal:

The fact that they have not blown up in the past doesn’t mean that they’re not going to blow up in the future.

In that case, it’s not clear why Fannie Mae would be different from all the other financial or non-financial companies that can’t exactly estimate either all the factors that affect their business, and that haven’t blown up yet either. Given what’s happened afterwards, can’t we credit the models for demonstrating that, at least, the company’s management assurances were misplaced, despite their not being exact (duh…)? It seems ‘the large staff of scientists’ deemed the events not so unlikely (or else the whistleblower’s name was Fat Tony and the ‘models’ were not really models at all but just his gut instinct).

If by now you haven’t completely lost confidence yet in Taleb’s prophetic skills, perhaps this will: as Eric Falkenstein pointed out on his blog, the risks discussed in the NY Times article pertained to interest rate risk: the losses that Fannie May would incur in case of a sudden jump in interest rates:

Fannie Mae and other big holders of mortgages and mortgage-backed securities chronically underestimate the odds of a big move in interest rates that could devastate the value of their portfolios, said Nassim Nicholas Taleb. (emphasis added)

What caused the collapse of Fannie and Freddie, however, was not a jump in interest rates; rather, it was rising default rates on subprime mortgages and falling home prices. Credit risk, not interest rate risk. Thus, Taleb proves to be no better than the seers and psychics who routinely shoehorn events to vague claims they’ve made in the past, using opportunistic reinterpretations of their previous claims.

In an article^[1] he submitted to the International Journal of Forecasting, Taleb went even further. Just like the fisherman whose fish grows in size each time he tells the story of his catch, Taleb inflates his Fannie Mae ‘prediction’ into a warning about ‘the total collapse of the banking system’! And notes that:

It appears scandalous [sic] that, of the hundreds of thousands (!!!) of professionals involved, including prime public institutions such as the World Bank, the International Monetary Fund, […], only a few individuals considered [that] possibility.
[…]
Not a single official forecast turned out to be close to the outcome experienced [sic].
[…]
A few warnings about the risks, such as Taleb (2007a) (The Black Swan, JV) or the works of the economist Nouriel Roubini, went unheeded, often ridiculed. Where did such sophistication go [sic]?

Good question, where did it go? Hiding underneath the feathers of a black swan, I guess.

Enough about Taleb for the moment. I would like to mention two other persons who are credited with remarkably good predictions about the crisis. One of them is rather well known in the world of finance, the other less so (except in his homeland Belgium).

The first is hedge-fund manager David Einhorn, who is said to have predicted the demise of Lehman Brothers. In a debate with Aaron Brown in GARP Risk Review June/July 2008 (‘Private Profits and Socialized Risk’), Einhorn explained why his Greenlight Capital hedge-fund was short Lehman Brothers stock. Just a couple of months earlier, Bear Stearns had collapsed and was sold to JP Morgan at a fire sales price. Einhorn argued that Lehman Brothers shared many of Bear Stearn’s problems, like a high exposure to US mortgages and too much leverage. Einhorn’s bet was remarkably timely: Lehman Brothers declared bankruptcy in September of the same year.

In my opinion, Einhorn deserves credit, firstly, for his profoundly accurate and detailed analysis of Lehman’s situation, and secondly, for putting his money where his mouth is (I don’t think Taleb shorted Fannie Mae). But to people who would conclude from this that Einhorn predicted Lehman’s collapse, I would like to add some reservations.

If a hedge-fund manager is short a stock, it’s not necessarily a bet on the company’s bankruptcy. All it takes for a shorter to make a profit is that the stock price goes down, so that he can buy it back more cheaply. A shorter can lock in his profit after a fall of 10% or 20%, or as soon as he thinks the price is not likely to fall much further, or the risk of a stock price recovery outweighs the potential returns from maintaining the short position. Most shorters don’t hold their position until the company is bankrupt. They take their profits and hunt for the next overpriced company. That’s why I find it a bit too charitable a conclusion that Einhorn predicted Lehman’s bankruptcy (let alone the whole financial crisis with all its ramifications). Without a doubt, he correctly predicted an underperformance of Lehman’s stock, but that’s not the same as a bankruptcy. Einhorn left open the possibility of the company eventually getting things back in order (perhaps after firm requisitions by supervising authorities):

[…], in any forthcoming recovery, Lehman might underearn compared to peers that have been more aggressive in recognizing losses. Further, I do expect the authorities to require the broker-dealers to delever. (emphasis added)

The second person I want to mention is the Belgian economist Geert Noels (then working at Petercam, now Econopolis. As Taleb has told us, economists are – without exception – pseudo-experts who are wont to use the Gaussian and who are blind to the nonlinearities (whatever that means) that pervade the real world, causing them to be ignorant of complex systems and hidden risks, and making them poor forecasters. Geert Noels, despite being one of those poor forecasting Gaussian-wielding nonlinearity-ignoring pseudo-experts, wrote an interesting column in the weekly Dutch-language magazine Trends, with the prophetic title Requiem for House.com (Trends, September 7, 2006).

At that time, there were already worrying signs that the US real estate market was heading for a not-so-soft landing, which Noels nicely illustrated by means of a chart showing a steep decline in the National Association of Home Builders Index. The phrase ‘House.com’ was an obvious reference to the Nasdaq dotcom bubble that burst in the early 2000’s. But, said Noels,

This bubble surpasses the Nasdaq bubble for the following reasons:

• The value of real estate in families’ total assets is twice that of equities, and many times greater than that of technology stock;
  
• Real estate is much more often purchased with borrowed money, […], increasing the likelihood that a price correction leads to big financial problems.
  

Noels also warned his readers that they should not pay too much attention to the soothing public statements issued by financial institutions, adding that:

• Real estate prices are not transparent; you don’t know if the price of your house has fallen until you want to sell it.
  
• Brokers and institutions take measures to conceal the problems (like reducing the number of ‘for sale’ signs put in front of houses).
  
• Professionals engage in obscure transactions, exchanging property among themselves at inflated prices with the sole purpose of keeping current price levels up artificially.
  

As it turned out, all these phenomena were later identified as playing an important role in the ensuing financial crisis. But Noels’ last paragraph was most truly prophetic:

The US real estate market has been crucial to the world economy. Thus, it is unlikely that a hard landing of the US home market will remain confined within the US.

Clearly, it didn’t.

No doubt one of the reasons Geert Noels is not widely touted as a prophet of the financial crisis (not even in Belgium), is because he doesn’t tour the world giving expensive talks and advertising himself as a prophet (while calling his less-gifted colleagues idiots). The man does what you expect from an economist: he follows the news, gathers data, reads statistics, puts a lot of effort in thorough research and analysis, and makes both interesting and novel points; insightful, well-argued and based on official facts and figures. Contrast that with dim-witted contenders who attribute all the world’s problems to the alleged tendency of experts to mistake nonlinearities for linearities (like a circle for a square, probably…)

Now that we’ve come back to Taleb, I would like to use this excellent (and funny) quote by Eric Falkenstein as a conclusion:

Perhaps you have heard of the Sub-prime debacle? Nassim called it. Whatever unexpected that happens you’ll find that most of the experts didn’t expect it–just as Taleb predicted. Space Shuttle? Berlin Wall? Britney’s meltdown? Again, these thing were big events, and most experts didn’t expect them, so Taleb did. Well, actually all he said was that unexpected things happen a lot. Is that a correct call? If you believe so, you are a Taleb fan.

I rest my case.

[1] Nassim Nicholas Taleb: Errors, robustness and the fourth quadrant, International Journal of Forecasting  (2009), article in press, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1343042 . How such a badly written article, containing numerous errors and unusually (for the type of publication) blunt comments, made it into an otherwise unsuspected scientific journal is a juicy story in its own right, the full details of which I haven’t unraveled yet. But as soon as I have, I’ll put the full account on QuixoticFinance.com – promise!