2010 : Financial Feast of the Black Swans

Accurate and timely financial forecasting has always been difficult. Especially today, with so many distortions at work in the economy, I can confidently say that no one knows with any degree of precision what the future may bring. Still I believe that there is a strong possibility that in 2010 the tender green shoots of 2009 will be violently chopped down to be replaced by a feast by a flock of black swans from hell. And that our economy will be the meal.

The concept of “Black Swans” was developed by Nassim Nicholas Taleb and refers to high-impact, hard-to-predict, and suppose to be rare events beyond the realm of normal expectations. In portfolio management these are events that are computed to be well outside of the range of statistical probability and are therefore of such a low risk they are not considered relevant to the risk management of the portfolio.

Unfortunately, in 2007 and 2008 black swan events happened so close together and had such a disastrous effect on the world economy that “rare events” were occuring one after the other. Clearly the hedge fund operators and bank traders had mispriced risk by huge margins. Black swans were everywhere.

Nassim Taleb was right with his statements that black swan events happen far more often than anticipated by number crunchers and portfilio managers. I have previously posted in my Taipan Investor Blog about Black Swan Events. Those readers not that familiar with the black swan concept may want to read the post before pressing forward.

Financial events in 2009 have paved the way for a flock of really nasty black swans to emerge in 2010 – the black swans from hell. Since by their very definition black swan events usually happen without warning forecasting their arrival is indeed a tricky business. However, actions already taken by the United States government, various USA state governments, and governments of other developed and developing nations move forward the probability of 2010 being a black swan hell off the charts. Here is why.

1.) Governments Attempting to Cure Problems Caused by Too Much Debt by Issuing More Debt.

The sad development of bubble economies in the recent past is well known. There was the dot.com bubble, the real estate bubble, the stock market bubble. the consumption bubble. As each bubble began to implode various governments of the world, lead by the US, tried to reinflate the old bubble or to inflate a new bubble. Even though the bubbles were largely caused by governments keeping interest rates far too low for far too long, all the while creating new fiat currency, governments seemed to say “what bubble”, let the good times roll. This misguided policy, which results in massive misallocations of capital, continues.

In the US, the Treasury Department will run a huge dollar deficit in 2010. The Obama administration said the economic downturn has been a bit worse than previously thought. It’s estimate for the 2010 budget deficit has been updated – increased by 19% – to $1.5 trillion. The Congressional Budget Office did its own count and came up with $1.4 trillion. Either way, when you get into the trillions it’s a hell of a lot of money. So much, in fact, that the human brain can’t seem to get a handle on it. Debt in the trillions will create fertile breeding grounds for black swans from hell.

2.) Confidence Building Rather Than Fixing Problems.

The year 2009 has lead to a multitude of reassuring comforting statements from all of the important con men and women, errrrrr, excuse me, government spokespersons, from President Obama, Ben Bernanke, Tim Giethner, and FDIC chairperson Sheila Bair. Not to worry, they all say in perfect harmony, green shoots are coming up everywhere.

In 2010, as the very temporary boost to the economy by programs like cash for clunkers and other stimulius programs falls away, the replacement of green shoots by black swans is almost certain to occur. The stimulius programs do not fix anything. We are not in a recession but in a depression caused by a systematic failure of our consumer based economy. While confidence building is an important function of government, leaders cheerleading without putting effective policies in place will lead to disappointment and anger.

Disappointment and anger will lead to more fertile breeding grounds for black swans.

3.) Feds Balance Sheet Already Doubled.

The Fed’s balance sheet is the monetary ballast for the whole economy. As the balance sheet expands, so does the amount of financial activity the economy can support. The problem is that in theory, the potential for inflation increases geometrically. Each new dollar on the Fed’s balance sheet could be multiplied into $10 in the real economy. Bernanke has already doubled the Fed’s balance sheet – buying up an additional $1 trillion worth of Wall Street’s toxic waste failures and the Federal Reserve Bank’s. According to Goldman Sach’s top economist, Jan Hatzius, Bernanke might have to buy another $2 trillion worth in 2010 – bringing the total to $4 trillion.

Black swans from hell must love those trillions.

4.) Number of Troubled Banks Keeps Increasing.

The FDIC reported on Thursday, August 27, that the number of troubled banks rose to 416 at the end of June, up from 305 at the end of March. Says MarketWatch: “FDIC said this is the largest number of banks on its ‘problem list’ since June 30, 1994, when 434 banks were on the list. Assets at troubled banks totaled $299.8 billion, the highest level since Dec. 31, 1993, the agency said.”

So far this year 84 FDIC insured banks have failed. With the FDIC’s funds to support bank failures fast approaching zero, it is highly likely that the FDIC itself will have to be bailed out in 2010. Who knows what type of black swan might show up to feast at a FDIC bailout?

While time and space do not permit a full listing of the potential back swans that 2010 may well bring to our weakened economy you can be assured that 2010 has a good chance of being a black swan heaven and an investors hell. 2010 ten has a real chance of surpassing 2008 as a prime year for black swans. Should a record number of black swans be recorded in 2010, however, the record may not last very long. With another round of mortgage resets peaking in 2011 the hell caused by black swans may be with us for a very long time.

Black Swans love to be underestimated. As uninvited guests it seems that they can wreck their havoc in spite of our best efforts to set up defenses. The challenge is to defend against what? Black swans arrive suddenly, attack spots that we don’t even realize are weak, and cause unforeseen consequences. The defenses we established often work against us and become their allies.

2010 is all too near. We had better brace ourselfs for a financial feast of the black swans.