Systemic Risk and Black Swans

“Black Swan” events such as Ponzi Schemes, earthquakes, tsunamis, have seemingly conspired to compel us to take our eyes off the “ball”.

As Financial Expert Fred Rosenberg reported about systemic risk and responsibility, “Since the mid 1990s, public investors – those ordinary working people and retirees whose life savings have been sucked into the financial maelstrom – have been systematically victimized by what can only be characterized as a Ponzi market that finally went nuclear in 2008, devastating the lives and hopes of millions. The responsibility for this investor catastrophe rests squarely on the financial services industry, its sales representatives, managers and quasi-professionals who have consistently misled investors about their professed ability to control portfolio losses in any meaningful manner. Worse, they have negligently if not recklessly kept investors in the dark about the overwhelming problems associated with systemic risk.

Under normal market, negative events generally occur randomly and most often are offset by non-correlated events moving in a positive direction. This is the rationale for diversification. But, when, negative events begin to occur in concert, they become correlated and their combined negative effect is amplified across the entire economy.

Systemic risk- the risk of a catastrophic collapse of the financial system- by definition is non-diversifiable. In a systemic meltdown, the interconnection and interdependence of large financial companies through complex financial dealings such as credit default swaps, overnight lending, underwriting, and loan participations, means that the failure of just one can set off a chain reaction of failures that jeopardize the entire financial system, exactly what happen in 2008. “Too Big to Fail!” became the bailout mantra, as insolvent of companies like AIG and Citigroup could not go down without all of their counterparties toppling like dominoes. In short, the sources of systemic risk are the financial companies and counterparties themselves. That is exactly the problem.

The collapse in housing prices in 2006 and 2007 led to a collapse in mortgage backed securities, which when marked-to-market caused insolvencies and capital impairments that triggered a credit crunch. Financial derivatives used to hedge the risks of assets of dubious if not unknowable value contributed to gross instability if not outright failure of premiere commercial, banking, insurance and investment companies and their counter-parties. Without credit, retail sales foundered in all sectors. Unemployment ballooned with the uncertainty brought about by frozen credit markets and declining retail sales that further stressed the economy.

For investors, the economic collapse in 2007 and 2008 cascaded across all investment sectors and asset classes, leaving them scratching their heads upon reviewing their monthly statements. Years of savings evaporated amid conflicted recommendations to ride out the crisis.

Advice to public investors to stay the course and diversify proved catastrophic in 2008. Such advice negligently ignored the economic turmoil driving the markets every day in favor of strategies based upon the historical analyses of financial markets that resemble contemporary markets in name only. Given that most investors are incapable of efficient hedging against catastrophe, the only advice to protect one’s investments during a systemic crisis is to tactically rebalance and ride out the storm in cash, savings bonds or other instruments with strong credit backing and little market risk.

Unfortunately, too many financial services professionals, brokers, financial planners and investment advisers grew fat selling and allegedly managing investments without any concrete understanding of the risks they promised to control. Worse, they uniformly claimed credit for the appreciation occurring during rising markets while disclaiming liability for their failures when the markets reversed. Furthermore, the income, bonuses and wealth of these self-professed experts are actually correlated directly with their success in preventing ordinary investors from exiting high risk markets.

The facts are crystal clear: public investor were simply kept in the dark by those whose profits, fees and commissions derived explicitly from keeping them fully invested even as disaster consumed their savings. Ironically, even after a decade of unmitigated failures, many of these self-styled professionals are still in denial about their ability to control portfolio risk through their “set it and forget it” strategies and mathematical projections. Many advisers today are even claiming victim status at the hands of Wall Street’s financial alchemists whose alphabet soup of concoctions by every measurement make the Madoff scam seem amateurish if not picayune.

For retirees, the greatest risk is not that their portfolios decline to zero, but that they may not be able to rebound from a decline in excess of 30%. More that have at least a 15 year time horizon may have the staying power to recover, but those with lesser time horizons are just beginning to realize that the greatest risk they accepted was trusting brokers and brokerage firms who did not know or care what they were talking about!