x Abu Dhabi, UAEMonday 22 January 2018

Beware of Swans - particularly black ones

If anybody, either on Wall Street or in the City of London, is surprised by events, then they have only themselves to blame.

Seldom seen, much admired. Nassim Nicholas Taleb advised the financial world to expected the unexpected in his book The Black Swan.
Seldom seen, much admired. Nassim Nicholas Taleb advised the financial world to expected the unexpected in his book The Black Swan.

When Zhou Enlai, the Chinese premier in the 1970s, was asked what he thought of the French Revolution - which had begun two centuries earlier on July 14, 1789 - he replied that it was too early to say. In a similar fashion, it is perhaps too early to comment on the past week's tumultuous events on Wall Street. Was there insufficient regulation? Or was it enough, but were the regulators too lax? Will legislation now be introduced in a hurried fashion, even though this is often the worst thing to do? Is the best way to stop a stock market from falling to stop it trading - as Russia did last week? Or is it to prohibit short-selling - a practice in which dealers sell shares they do not have, in the hope they will be able to buy them for less money in a few days' time and pocket the difference? This is what many markets around the world have done, even though short-sellers provide valuable liquidity and are the only people selling in a bull market.

If anybody, either on Wall Street or in the City of London, is surprised by events, then they have only themselves to blame. They should have heeded the warnings of one of their practitioners. The Black Swan, by Nassim Nicholas Taleb, was published last year to widespread reviews and enthusiastic sales. Like the authors of most business books, Taleb, a former bank trader turned sceptic, manages to turn one simple concept into 300 pages. His idea is this: for thousands of years people believed that all swans were white. There was no evidence to suggest otherwise. It was only with the discovery of Australia that people discovered that there were, in fact, black swans floating on the Murray River.

His thesis is that we should expect the unexpected, because it happens more often than we can imagine. Nor should we take history as a reliable indicator of the future. Consider the case of the turkey. From birth, food is pushed down its throat. Every day follows the last in an orderly fashion, until one day the hand that used to feed it goes around the bird's neck and throttles it. This is what happened to investment banking last week. Like turkeys, the bankers were standing around with their mouths open waiting for their next bonuses, only to find that, Soviet-style, they are now all either owned by the government or fiercely regulated by them. They should perhaps count themselves lucky they were not lined up and shot.

But how did the turkeys on Wall Street fail to notice the signs? Bleary-eyed bankers could be seen on the London Underground or the New York subway with the book under their arms. Did none of them read it? It is true that it is quite smug and irritating and the author saves the best until last, but anyone who reached page 225 would discover a section called Naive Globalisation. Taleb writes: "We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are inter-related. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks often Gaussianized in their risk measurement - when one falls, they all fall."

Sounds rather like the events of the past few weeks, doesn't it? He even goes on to say he thinks Fanny Mae, the government-sponsored mortgage provider, is "sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events 'unlikely'." While Taleb suggests we should not use history to predict the future, it seems likely that there are four main implications we can draw from last week's events.

1) Damage to brand America. As if President George W Bush's tenure had not done enough to damage America's political standing in the world, he also managed to tarnish its financial standing. America's investment bankers ruled the world, their brand of innovative capitalism fuelling a boom of epic proportions. Say what you like about Wall Street, but innovation such as the internet would not have been possible without them. Without Wall Street's creativity, we risk a slower, less innovative time.

2) More regulation will lead to a slowdown. The way to stop the excesses of the financial system is, of course, to regulate more. It is not true to say there was no regulation. It was just that nobody was prepared to be the one calling the party over. However, with all the glasses spilt and the guests gone home, it is clear that it has ended. But there is no guarantee that politicians and bureaucrats will be any better at banking than bankers. Their instinct will be to do nothing - just like a French banker. Mortgages and loans will be harder to come by. It may be time to start saving.

3) Do not believe in decoupling. Anyone who believes that the Gulf can somehow march to a different beat is surely out of step. The fact that the Central Bank of the UAE had to make Dh50bn (US$13.6bn) available for banks when international interbank lending dried up is just one indicator. If the world economy stalls, demand for oil will drop. This will affect the price and have a knock-on effect on government spending.

4) The lessons of leverage. One of the things that did it for Lehman Brothers was that its exposure was more than 30 times its capital. Leverage is the way that investment bankers make their money - lots of it. This, as we have seen, is fine while the markets are going up. When the market turns, it is disastrous. In Dubai, and to a certain extent in Abu Dhabi, we have seen a property market that verges on ludicrous. Speculators have been buying off-plan and for, say, an initial stake of US$10,000 (Dh36,700) for a $200,000 property, selling it for $400,000 - often before a brick had been laid. We can probably surmise that those who did it once wanted to do it again. Rather than buying one property, they bought 10, or 20. When the market turns, which it surely must, those $200,000 gains - multiplied up to $2 million or $4m - will turn into losses. Banks in Dubai may suddenly end up owning a lot of empty properties worth a fraction of the previous year's value.

The central bank will find that it needs more than Dh50bn to bail them out. When that happens, we will all believe in black swans - even Zhou Enlai. rwright@thenational.ae