The book, “Stalking the Black Swan” talks about how to make decisions in a volatile world, and it includes case-studies from the fast-moving world of financial markets, where reacting accurately to new data is a critical survival skill.  However, as my friend Howard Ecker points out, individuals may be able to take out “insurance policies” against Black Swans by structuring certain kinds of options into long-term contracts.  The idea is to build flexibility into long-term contracts, so that if and when crisis strikes, the firm has room to respond.  Howard is an experienced commercial real estate practitioner, and many years ago I worked with him to structure options in commercial real estate leases to protect corporate tenants from financial volatility.

As a reminder, Black Swans are Nassim Taleb’s term for seemingly unpredictable surprises with extreme impact.  Commonly associated with the Great Recession we have recently experienced (and whose after-effects still linger), Black Swans can also impact individual companies or industries, even when the rest of the market is calm.  For example, in an earlier post (August 22, 2010), I described how a company called APEI suffered a Black Swan that knocked 50% off of its stock price in 5 days.  Each chapter of “Stalking the Black Swan” contains examples of one or more Swans and a discussion of their causes.

One cause of Black Swans is leverage, which includes not just debt, but any kind of fixed cost.  Real estate developers commonly fall victim to Black Swans, because they operate with high leverage, which leaves them exposed to a correction in real estate values.  However, volatility in property markets is also a problem for tenants.  For many firms, long-term commercial real estate leases are a major fixed cost and thus potentially a source of dangerous leverage (this is why analysts treat leases as if they were debt obligations when analyzing the risk of a firm’s balance sheet). 

Consider a hypothetical law firm with a practice in commercial real estate that signs a long-term lease at the top of the market.  Or a securities firm that expands when stocks are booming.  When the inevitable bust arrives, the firm’s revenues drop, yet the costs of its lease remain fixed.  As a result, margins are squeezed.  If the crunch is tough enough, the firm may turn unprofitable.  Even if it maintains a positive cash flow, it may have to cut wages or let go staff, which makes it less competitive.  Conversely, an unexpected boom can produce a surge in revenues and expanding margins.  However, if many firms are doing well, they may compete for space for their expanding operations, in the process bidding up rents.  If this happens at the peak, then firms which lock in high-priced space could find themselves in a difficult position when business slows.

As Howard reminds me, you can mitigate some of this kind of Black Swan risk by structuring options into long-term leases.  These options come in different flavors:

• A cancelation option allows the tenant to terminate the lease (or a portion of the lease) at a specific date, providing flexibility for the firm to downsize operations and cut costs if business is suffering.
• Many leases have renewal options, but these terms are more valuable if they specify a fixed rental rate for the renewal period.  This option protects the tenant from having to pay sky-high rates if the commercial real estate market tightens, which as pointed out above could set the tenant up for problems in a market correction.  Yet if the market softens, the tenant is under no obligation to exercise the fixed-rate renewal option, but may instead negotiate a renewal at the prevailing market rate.
• Options to expand the space under lease at specific fixed rates provide similar benefits to fixed-rate renewal options.

In the 1990s, I published several articles on how to estimate financial values for these options, as a guide for savvy tenants and their representatives (for example, see “The value of options in real estate leases,” Journal of Property Management, May 1994).  Even without putting specific values on the options, however, it should be clear that they provide excellent insurance against Black Swan risk by building flexibility into what are otherwise long-term, fixed-cost contracts.

Building flexibility into contracts is an idea that has many applications in a volatile world.  For example, bank regulators are experimenting with so-called “living wills” which would make it easier to wind down big banks if they got into trouble (instead of having to bail them out).  Another idea is to have big banks issue a kind of “contingent capital” which would automatically replenish their reserves during a financial crisis. (You can find a discussion of these ideas in my recent article, “Thoughts on the Squam Lake Report,” in the Journal of Applied Corporate Finance, available at www.stalkingtheblackswan/articles.html). 

This post is an excerpt from a presentation I made in Winston-Salem, NC on Saturday, September 11, 2010.  The presentation slides will be available shortly at www.stalkingtheblackswan.com

The problem with financial crises is that financial firms are so interconnected:  the failure of one firm may unleash an unpredictable cascade of defaults at other firms, risking a severe economic downturn.  Even the possibility of failure is enough to freeze the capital markets, as investors brace for the next domino to fall, and then the next after that.  No surprise that regulators step in to bail out financial firms when they start to wobble.  Costly and unpopular, yes, but bail-outs are better than risking the collapse of the financial system under a wave of defaults (as we saw with the decision to let Lehman fail).

There is a better way.  The Dodd-Frank Financial Reform bill contains important provisions that establish a Financial Stability Oversight Council, which will be supported by a new treasury department, the Office of Financial Research, and gives these entities significant budgetary resources and legal powers. 

In a nutshell, the bill has created a kind of “air traffic controller” for the financial system – a function that historically has been lacking.

Traditionally, financial regulators have supervised individual financial firms.  Supervisors make sure each financial firm has adequate capital and follows sensible policies.   In this way, they act much like the Federal Aviation Administration (FAA), which takes steps to ensure that aircraft are properly maintained and safe to operate.  Without air traffic controllers, however, two perfectly safe aircraft could still crash into each other.  Similarly, two financial firms that had passed their regulatory exams could still get into trouble in a crisis, if they had counterparty relationships with other, riskier firms.  Both airplanes and financial firms have “interconnections” that need to be monitored and managed. 

As strange as it may seem, there, there is no financial equivalent of the air traffic controller.  No-one in government systematically monitors interconnections.  That is part of the reason that Fed chairman Bernanke and treasury secretary Paulson struggled during the crisis, bailing out some firms that were obviously systemically important, but missing others (like Lehman).

The Office of Financial Stability Oversight could make a big difference:  instead of supervising individual financial firms, it would study their interconnections.  This would require two steps, which the Dodd-Frank bill delegates to the Office of Financial Research:

·         An information technology system would aggregate real-time data on counterparty exposures from regulated financial institutions and any unregulated firms that regulators think might pose systemic risk.  This information collection need not be burdensome:  the reporting could be programmed into the firms’ own risk-management systems.  Given the large number of firms and interconnections, and the speed with which they change, regulators would never have a complete view.  But any systematic collection of information would be an improvement over the current situation.

·         A judgmental approach in which highly experienced regulators from the Office of Financial Research would visit any financial institutions that caught their attention, interview management, and inspect their transaction records, in order to stay abreast of new trends that the IT systems might not pick up.

The goal of this two-pronged approach would be to identify firms that, because of their interconnections, might pose systemic risk.  For example, had it been in place during the crisis, the Office of Financial Research might have identified AIG as posing systemic risk because several large investment banks depended on it for billions of dollars of insurance against subprime mortgage losses.  Or it might have discovered that money market mutual funds held large amounts of Lehman’s debt.   Or that many banks held preferred stock in Fannie Mae and Freddie Mac.

Firms with these levels of interconnections pose systemic risk because their failure could cause other firms to fail, too.  Regulators should require these firms to hold extra capital for the risk that they pose to the rest of the system.  That requirement would encourage the firms to shrink or reposition their business, to bring the interconnections back under control.  And this would help make the financial system more robust in the face of the next “Black Swan,” whatever and whenever that might happen to be.

We live in a world that is punctuated by bursts of extreme volatility, including so-called “Black Swan” events.  Decision-makers need to adjust accordingly.  One technique I recommend in the book, Stalking the Black Swan, is monitoring volatility indicators, including the volatility implied in option prices.  The CBOE’s popular VIX index tracks the volatility implied in options prices for the stocks in the S&P 500.  The VIX thus gives us a clue as to the market’s view on uncertainty. 

The current reading on the VIX index is similar to those of past recessionary periods.  CEOs should focus on near- to intermediate-term planning and be prepared to drop (or rethink) long-term plans if economic conditions remain tough.  Investors should exercise some caution in buying stocks – for example, being skeptical about long-term growth plans and watching near-term data for clues that a company’s business model might be breaking down.  But I don’t think investors should be bracing for crisis – unless they have identified a specific hypothesis about why a crisis will appear.

Exhibit 1:  Historical VIX levels 1993 -2010

[If chart is not visible, please refer to the original blog post at www.stalkingtheblackswan.com]

Source: CBOE at http://www.cboe.com/micro/vix/historical.aspx

Let’s take a look at the historical time series for the VIX in Exhibit 1.  What do these numbers mean?  They correspond to the annualized volatility implied in options prices for S&P 500 stocks.  For example, a VIX level of 10 can be interpreted as follows:  traders collectively estimate that were a one-standard deviation shock to occur, the S&P 500 would move up or down by roughly 10% over a one-year period.  If the S&P were at 1,000, then a one-standard deviation shock would be a 100-point move in either direction.  According to the Normal distribution, a one-standard deviation shock (or greater) ought to occur with a probability of about 33 1/3%.  To be sure, the Normal distribution does not perfectly describe stock price changes.  But the terminology is useful as a first approximation of how people in the market think and talk about and price for uncertainty.

We can see three different levels of volatility during the historical time series:

·         During “good times,” such as the period of strong economic growth from the early 1990s to the late 1990s, the VIX traded between 10 and 20. 

·         During recessionary periods, we observe historical VIX levels of 20-30 with occasional spikes to 40, for example in the early 1990s, or in the aftermath of the 2001 recession.  The VIX index was also elevated during the 1998-2000 run-up to the technology crash, as much speculation, debate, and hence uncertainty surrounded the value of popular technology and internet stocks in the S&P 500.

·         During the financial crisis of 2008, the VIX spiked to 80, a level never seen before, as investors braced for a global capital markets and banking crash and the possibility the US and other developed economies would sink into depression.  Massive government intervention helped restore some confidence, and the VIX gradually sank back to more ordinary levels, punctuated by a spike above 40 as investors grappled with the implications of the Greek sovereign debt crisis.

As of Thursday evening, the VIX was trading around 23, a level that is similar to past recessionary periods, but not the panic associated with a potential crisis or crash.

What does the VIX mean for corporate decision-making?  As I explain in Stalking, decision-makers should flex their planning horizons to reflect the level of market uncertainty.  During “good periods,” it is appropriate to make long-term plans.  But long-term planning is not realistic during a crisis.  Rather, the focus should shift to near-term data that will help executives navigate a treacherous environment. 

For investors, a reading of 23 on the VIX argues for a moderate amount of caution before buying stocks for long-term investment and the need to watch near-term data more carefully.  Recessionary times test a company’s business model, revealing just how strong a firm really is, and how much of its past performance was due to strong economic conditions, luck, or possibly risk-taking.  In today’s environment, before buying the stock of a favorite company on a dip, think about what indicators you would like to see in the next quarter’s results that will shed light on how strong that business model really is. 

Many investors are still smarting from stock market losses during the crash of 2008.  However, a reading of 23 is not high enough to indicate market fears of an impending crisis, so these investors might want to think about dipping their toes back in the market. 

To be clear, no-one should take the VIX index or any other indicator as a guarantee of future risk levels.  After all, the market is made up of individuals, all of whom are capable of being wrong or getting surprised.  The point of watching indicators is that they allow us to “calibrate” our thinking with that of other investors – a starting point before coming up with differentiated investment hypotheses, where we disagree with others and expect to profit from their mistakes.  For investors who do not have differentiated views on macro-economic or market trends, keeping an eye on the VIX index could be a helpful discipline.  

A recent Wall Street Journal article by Jane Kim, “Preparing for the Next ‘Black Swan’” (August 21, 2010) describes a variety of investment products designed to protect investors from ‘Black Swans,’ the term coined by Nassim Taleb for seemingly unpredictable surprises of severe impact.

My view:  buyer beware.  For a number of reasons, I am skeptical that these products will provide value-added returns.

·         Black Swans don’t have to be bad.  The term “Black Swan,” as I understand and use it, refers to an outcome where the market is caught off guard by elevated volatility.  Right now, in the aftermath of the Great Recession, many are focused on downside scenarios.  But surprises can be positive as well as negative.  For example, in my book Stalking the Black Swan, I describe a positive Swan involving the IPO of MasterCard, which produced an 800% return in 2 years.  Most of the “Black Swan strategies” described in the Journal article are really bearish strategies, meant to profit from or protect investors from market selloffs.  There’s nothing wrong with being bearish, but you don’t need a fancy (or expensive) strategy to express a pessimistic view of the world.  Instead, you can hold cash or short stocks.

·         Some of the Black Swan strategies offer “insurance” against market selloffs, typically through the purchase of put options, which gain in value when the option’s underlying stock or index sells off. But such insurance is costly, and if the feared-for event fails to materialize, the cost of the insurance will eat into returns.  Consider:  the broker-dealer taking the other side of the option trade needs to cover its hedging costs and earn a return on capital.  There is nothing wrong with buying insurance.  But one should ask the question whether such insurance is likely to be sold at a bargain, or whether the counterparty is expecting to be compensated handsomely for protecting against Black Swans.  A cheaper (and simpler) hedge against downside risk is to keep a higher proportion of assets in cash.

·         To minimize the cost of buying options, some Black Swan investment strategies focus on deep out-of-the-money put options, which will produce returns in extreme sell-offs.  The idea is to profit from the fact that the market continues to ignore the risk of extreme events.  But does the market really misprice such risk?  True, Taleb performed a service by popularizing the idea of Black Swan risk – but it’s not really a new idea.  Benoit Mandelbroit wrote about fat-tailed financial returns in the 1960s, and the topic has been studied extensively since that time, especially in the aftermath of the 1987 stock market crash, which was seemingly an 11-standard deviation event (according to the level of volatility prevailing before the crash).  In the aftermath of the Great Recession, the “flash crash,” and the Greek debt crisis, many people are now focused on the risk of extreme but unpredictable risks.  Indeed the term, “Black Swan,” is now bandied about by the popular press.  To be sure, it’s possible the market is mispricing extreme risk, but to make an investment bet on this hypothesis requires some kind of rationale, which I did not see articulated in the Journal article.

I was disappointed that the article made no mention of how to think about Black Swans.  In Stalking the Black Swan, I explain a number of techniques for decision-making in a volatile environment.  These include forming hypotheses, thinking probabilistically across multiple scenarios, reacting quickly and accurately to new data, finding the right balance between over- and underconfidence, using judgment, and so forth.  To be sure, following this kind of discipline takes some effort.  But it may be worth a try before turning to Wall Street for peace of mind.