For some reason(s?) I decided recently to re-read “Manias, Panics and Crashes – A History of Financial Crises” by Charles Kindleberger and Robert Aliber. It reminded me that most of the financial crises in the last two centuries – and they have been accelerating in frequency in the last two decades – were largely a function of cross-border currency flows, leading to spikes in asset prices, and related nutty behavior which I will affectionately call investor mayhem.
Rising asset prices attract too many investors, the worst/weakest last, and unsustainable price levels are just that – unsustainable. When they fall, the most foolhardy fall with them, but corollary damage can be high. So the history shows, wherein the Crash of 1987, the Asian financial crisis of 1998 and the bursting of the tech bubble are relevant examples.
I may have been influenced to seek out the Kindelberger book again after a 20-year hiatus because of general trembling in the system, a condition that Kindleberger and Aliber remind us often presages A Very Bad Thing Happening. What trembling? Oh, high oil prices, Russian (Putin’s) intransigence, Middle East war developments, massive trade imbalances, the prospect of elections in the US - or perhaps my ongoing work with a bank in Japan, where troubling questions arise from the yen-carry trade (“How long can this go on? When will it end? How does it end when it does? Who wins and who loses?”) If the Bank of Japan remains trapped in low interest-rate conditions, maybe this just goes on as far as the eye can see, as more investors borrow cheap yen to buy higher return assets elsewhere. But I sort of digress…
I may also be induced into heightened a state of nervousness (or state of heightened nervousness) by the sub-prime loan situation in the US and related press. The stories, and the underlying fact that many assets have been priced on models not markets, so that prices are not well understood, and therefore not known, and so…) makes you wonder if termites might have been eating your vacation home all winter and as the summer crowd arrives, it’s about to all fall down.
We do not know where we are in the process of “working this out,” so we cannot say what may yet come of it. But nervousness abounds. The collapsing summer house is an imperfect (and perhaps overstated) analogy, but it is reinforced by another contemporary book that is getting some attention among strategists and investment professionals - “The Black Swan,” by Nassim Nicholas Taleb. “Black Swan” is a term for the thing that was thought not to exist (all swans are white) but which appears unexpectedly, as the Thanksgiving Day axe appears to a turkey who has become convinced that life is all about fattening.
The Black Swan concept is a bit elusive because it really means something that cannot be known in advance. Take for example the Middle East revulsion over all things Dutch in the wake of a political cartoon that suddenly destroyed the revenue of Dutch firms specializing in Middle East retail markets. The cartoon and its aftermath could not have been anticipated and for some was a perfect Black Swan - a sudden development for which they were totally unprepared, largely because they were too highly concentrated in an increasingly volatile environment.
Taleb, who also wrote “Fooled by Randomness,” is making a case that it is better to prepare for events that are highly improbable but have a huge impact than to participate in the stampede that will necessarily – in a manic, panic, crashing kind of way – lead much of the herd off the cliff. Taleb is also arguing that Black Swans and other asymmetric events provide massive opportunities for anyone who actually imagines them coming, and buys the appropriate options in case they do. We are left then with questions about how to anticipate and prepare for what we do not know and cannot know.
Here I am reminded of a case where scenarios to contemplate Y2K produced the thought that the Bank of New York would be unable to settle trades. This meant enormous enterprise risk for the likes of Morgan Stanley, for whom I was conducting scenario studies at the time.
Of course, Y2K came and went, the most outspoken Y2K crisis theorists ended up with some egg on their faces. The Bank of New York trading and settlement system was not a problem. However, on the day after 9/11, a top contingency planning item under discussion in Morgan Stanley’s command central was the fact that BoNY had lost its trading/settlement capability when a Verizon tower went down in the conflagration. Because of its Y2K scenario preparations, Morgan Stanley was unaffected. Thinking through a contingency that did not come to pass was the secret of success in one that did.
This all comes back now amid thoughts of foreign exchange-driven imbalances, assets and derivatives that are overbought and under-understood, and a general mood of trembling in the system that something is likely to break sometime soon.
Both Kindleberger/Aliber and Taleb are worth reading in this regard, if only to be reminded that Bad Things Do Happen, and while you cannot predict what they will be, you can prepare. Think the unthinkable. One way to do this is to think through scenarios, using the smartest and most imaginative people you can lay your hands on, to see if you can get close to anticipating, and therefore preparing for, the kind of thing that could happen. This will also force you to explore whether you and your enterprise are smart or courageous enough to buy options, or insurance, when others are pooh-poohing the risk or are simply too invested in the stampede du jour to reconsider the nature of the game they’re actually playing.