Black Swan...

David Usher writes a blog on which he muses about technology, telecommunications, public policy, regulation, society, media, war, culture and politics. He suggested I read "The Black Swan, The Impact of The Highly Improbable" by Nassim Nicholas Taleb. (You can find David's blog at http://davidusher.blogspot.com/. The book led to this fairly ridiculous correspondence between me and my brother in law the stock market guru whose most recent stock pick is Radio Shack (symbol RSH):

I replied to Bro-In-Law;

"I have, as you know, given up (for the most part) trying to either time the market or pick individual stocks on either a fundamental or technical basis.

Your recent suggestion, Radio Shack, (RSH) does seem to be trying to rebrand itself but I think it faces challenges. It is a nice store for small products when you want to talk to a salesman without the hassle of Best Buy hugeness but the Shack's salespeople are usually not very up to speed. I could see them improving by cutting out their poorly performing stores. I think of them as the electronic version of Starbucks, they have lost their way and are trying to get back to what they do well - they may succeed. I would be reluctant to be long on options now because the market seems over heated to me (but what do I know)?

I just finished reading Black Swan which I think agrees with your investment thesis. To sum it up, as I understand it, Black Swans are events that do not appear anywhere on the Bell Curve proving that the Bell Curve itself is inadequate as a model yet is widely utilized to this day (Black Scholes for example is premised on a bell curve methodology). Bell Curves work in predicting the range of possible outcomes of heads or tails (40 heads in a row is on the far end of the curve) but does not work for complex outcomes where the impact of one variable has a wide range (and ever widening as you move out in powers) of impacts on future outcomes (like the angle of a ball bouncing - the range of angle is further multiplied with each subsequent bounce. Thus all models that are based on the Gaussian Bell Curve are terrific for predicting likelihood of unrelated events but flawed for predicting events that are not independent of one another (which is how the real world works unlike flipping pennies). As Nassim Taleb says, "Remember that if either of these two central assumptions is not met, your moves (or coin tosses) will not cumulatively lead to the bell curve. Depending on what happens, they can lead to the wild Mandelbrotian-style (fractal !!! emphasis mine) scale-invariant randomness." (page 251).

Interesting - way over my head but confirms my belief that insurance companies had no business issuing credit default swaps to guaranty citi bank debt on Pachinko Parlors in Japan (which they did - see http://roughfractals.blogspot.com/2009/03/aig-behind-scenes.html.

The converse, "White Swans", can happen to the upside as well so Taleb's view is that investors should put most of their money in Treasuries and buy small amounts of options to take advantage of the unpredictable on the upside while limiting the unpredictable downside events by not buying too much of any one option."

AIG Bonuses

ROUGH FRACTALS does not often post in reaction to the specific day's news but the justification we heard today for the latest AIG bonuses to AIG Financial Products employees is just plain wrong. The rationale - that if these bonuses are not paid the employees will leave the company. Hello? - anyone still at AIG who is any good (and can get a job elsewhere) is going to leave as soon as they get these bonus checks. Why would anyone who is good (and can get a job at a live company) stay at a dead company except in order to collect these checks? So either way - the good people are leaving.

Why not put these bonuses into accounts that will be paid out at up to 150% of their face amount if certain benchmarks are met and the employees stay for say, 3 years? If they are fired or let go before the 3 year retention period has expired then they get paid what they would have gotten. If they leave of their own accord before the 3 year retention period they forfeit the bonus. That provides incentive, benchmarks and retention. Paying them now will not enhance retention it will simply accelerate the process of the talented rats leaving a sinking ship.

Alternatively, the bonus money could be used to hire new people who have lost jobs and would gladly work hard -like any number of the 50,000 recently laid off financial services workers or retired men and women with financial backgrounds who now need work because of losses in their retirement accounts.

Another red herring is the contract argument. Any law suits that might be brought on contact claims could be settled for a fraction of the face amount of the bonuses and, if done right, suits will be avoided because most people will sign up for the 3 year plan and sign releases.

Andy Borowitz of The Borowtiz Report got it right:

"MARCH 15, 2009
In New Terror Video, AIG Demands Huge Ransom from U.S.
Shadowy Group Seeks Bonuses, Golf Retreats

American intelligence experts are analyzing a new terror video from the American International Group (AIG) in which the leader of the shadowy organization demands billions of dollars from the United States.

In the four-minute tape, which surfaced over the weekend and caused deep concern among U.S. officials, a man believed to be the chairman of AIG says that if his organization is not paid its ransom, "chaos and destruction will rain down on the American economy."

"If we are not paid billions more in bonuses and corporate golf retreats, America will be made to suffer," the man threatens.

Intelligence analysts said that the man, AIG chairman Edward M. Liddy, appears to be speaking at a luxury beach resort that offers few clues as to his exact location, although there is "good intelligence" pointing to the Ritz Carlton in the Cayman Islands.

"We have some reason to believe that he and other AIG executives are there, based on a series of intercepted room service orders from the all-day dining menu," one analyst said.

Reacting to the video, Homeland Security Secretary Janet Napolitano raised the nation's terror alert level to orange, meaning "taxpayers are about to get reamed again."

Treasury Secretary Timothy Geithner also released a response to AIG's latest demands, but intelligence experts said they would need several weeks to decipher Mr. Geithner's response."

AIG - Behind The Scenes...

Since AIG is constantly in the news I thought I would submit this. My name is Dan Lowman and I work at AIG. I joined AIG in 2003 and am an analyst - I work in a cubicle surrounded by hundreds of other cubicles - we call our floor at 90 Pine Street, NYC - the Hole. I build financial models. A lot of people are wondering just what it is that got AIG into such trouble. That is a fair question and I try below to answer it.

It worked like this - say a Hedge Fund, call it Pagan, Inzano, Gotcher, Gall and Yanko or ("P.I.G.G.Y.") run by Mr. David Nutt wants to borrow $50 million dollars to invest in participation note revenue bonds issued by pachinko parlors in Japan called "Overseas Opportunity Participations" or "OOPs"). SEE FOOT NOTE 1.

FOOT NOTE 1: It wasn't just Pachinko parlors or just AIG - global insurance balance sheets of many companies were used to provide capital support to all sorts of projects, i.e., hydro electric plants in Columbia, airline ticket receivables in Peru, hotels, apartment investment funds, bonds with interest rates based upon the number of hurricanes in Florida, nationwide car dealership give-away contests based on snow fall accumulation on Christmas Day, any pool of any mortgages whatsoever or any other collateralized debt obligations of any kind such as credit card and auto loans ... and a whole host of other risks and projects all of which were grouped under my business division - "AIG Structured Solutions" or "ASS" (now referred to as "Structured Underwritten Products In Decline" or "STUPID").

Anyway, Mr. Nutt goes to its bank, "The Dumay National Bank" and is told that the cost of borrowing the $50 million will be 12% interest with a bullet payment due in 3 years because, after all, its a new business and Dumay does not quite understand the pachinko parlor business which it considers to be high risk. SEE FOOT NOTE 2.

FOOT NOTE 2: Pachinko parlors are big business in Japan - pachinko is a gaming device not unlike a pin ball machine - the amount the player wins in cash depends on which slots each ball falls through. Pachinko is as common in urban centers in Japan as Starbucks are in NYC - the parlors themselves are divided into two sections, a gaming center in front and the back is devoted to the sale of pornographic magazines and sex toys. Sake happy hour specials generally draw big after work crowds.

"Arrghhh" says Nutt - 12% is a really high interest rate - anything I can do to borrow at a lower rate for OOPs?" "Sure", says Dumay "just get an Insurance Company like AIG to guaranty the loan and since, if you do not pay, they will (AIG was rated triple A by S & P which means "sure to pay") we will lend you the money at 7%. SEE FOOT NOTE 3

FOOT NOTE 3: Hedge Funds borrow money for all of their deals - the idea is that if you make a dollar on ten cents your IRR (internal rate of return) would be much higher than if you put up all the cash. Hedge Fund Managers are paid from two pools - generally 2% of all the cash given to them by their investors (this pool was called "Pizza Money") plus 20% of the IRR (this pool was called the Incentive Fee) and together they were referred to as "2 and 20"). SEE FOOT NOTE 4.

FOOT NOTE 4: Under existing IRS rules Hedge Fund and Private Equity execs pay income tax on their Pizza Money but pay the much lower cap gains rate on the Incentive Fee because the IRS (after much lobbying by Hedge Fund and Private Equity donors to Congressional Campaigns) ruled that the Incentive Fee is not earned income but rather "return on capital". This is sometimes called the Bernie Madoff Rule.

So Mr. Nutt, looking to better deal the bank rate, goes to AIG and meets with the President and Vice President of AIG Structured Solutions, Mr. Hyram (Hy) Jeenyus and Ms. Mytee Vinegar, and pitches the pachinko parlor business. Now if Jeenyus and Vinegar do not close deals they do not get large bonuses - so, anxious to earn a healthy bonus, Hy and Mytee convince themselves and the rest of us working in the Hole at ASS that pachinko parlors are the next best thing since sliced bread and they build a really complicated business model on an exel spread sheet showing that it is impossible for P.I.G.G.Y. to lose money investing in OOPs. Jeenyus proposes to Nutt that AIG guaranty the loan to P.I.G.G.Y. in return for 2% of the loan amount plus 10% of the equity of OOPs (this was called "2 and 10"). "And here's the really genius part", said Jeenyus. "We do not have to put up any reserves since this is a guaranty not an insurance policy so its not even looked at by the Dumay regulators." "Pure genius, Jeenyus", exclaimed Nutt while Hy and Mytee slapped each other a high five. The caption under the photo in that week's AIG newsletter, the Daily Undewriters Herald or ("D.U.H.") was "Nutt does deal with Hy Jeenyus - OOPs."

Now there is a catch or two - Dumay Bank doesn't like to keep loans to P.I.G.G.Y. on its books - it prefers to "securitize" them (securitization was invented way back in 1963 by Richard Fuld, a then obscure junior associate at a firm known as Loeb Rhodes Hornblower. Update to present - Fuld is now serving time in a Federal Psychiatric Facility after strangling Elliot Spitzer who he ran into in the lobby of the Washington DC Mayflower Hotel in June of 2009. Fuld was apprehended at the scene, unshaven, reeking of alcohol and muttering to himself).

Back to our story: In order to securitize the pachinko parlor loans, the deal had to be rated by Moody's or Standard and Poors - what to do? Moody's does not really understand the pachinko parlor business but it does understand that the fees it gets for rating deals are, shall we say, lucrative, and since it knows how strong a company AIG is it figures - "oh, what the hell, lets have a look at that pachinko parlor exel spread sheet". So the Moody's senior executive in charge of ratings studies it. The model makes absolutely no sense to him but since AIG (which is too smart and too big to fail) will guaranty the Dumay loan he rates the deal AA+. A deal term is added that requires AIG to post collateral in the unlikely event AIG is ever downgraded. SEE FOOT NOTE 5.

FOOT NOTE 5: The likelihood of an AIG downgrade was shown on the exel spread sheet model as a 1 in 100 year occurrence. The model came up with these odds after running a "Monte Carlo simulation" (MC simulation being the name given to an an actuarial based computer program used to asses random event probabilities based upon thousands of computer generated possible outcomes.)

So the OOPs deal closes, Moody's gets its rating fee, AIG gets a Guaranty fee, Hy Jeenyus and Mytee Vinegar get their year end bonuses and Dumay Bank securitizes the P.I.G.G.Y. loan and sells it in tranches of $100,000 par value bonds to other hedge funds, banks, 401K's, money markets, and pension funds of large automobile companies.

Fast forward 12 months: turns out that in Japan the only pachinko parlor businesses that make money are ones with connections to the Mob who skim money from the machines in return for "protection" - their was no Mob Payments Calc Cell in the Monte Carlo simulation (When the Dumay Bank Regulators asked about this the Risk Manager at AIG, Dean Pisch, said - "Listen you Dumay Bank Regulators - we said low risk - not no risk". The pachinko parlor business failed, Dumay demands repayment, AIG has to pay. Moody's calls up AIG and says - "We have to downgrade you" (it wasn't just the pachinko business, it was also low airline ticket sales in Peru, a drought in Columbia, Hurricanes in Florida, plummeting mortgage values, defaults on auto loans and credit cards and, to top it all off, it snowed on Christmas Day requiring AIG to pay GM to give away 5,000 cadillacs to the lucky winners). AIG says, "Whoa, if you downgrade us that will trigger collateral requirements in all our deals." Moody's asks, "how much collateral would a downgrade trigger?" AIG says, "$20 billion, no $40 billion, no $85 billion" ... and the rest is history. (David Nutt and Hy Jeenyus were fired but were given hefty severance packages and use of a recently redecorated office at a now bankrupt but formerly very large financial institution - Mytee Vinegar and Dean Pisch are still employed at AIG).

Post Script: In the year 2012, after having contributed over $500 billion taxpayer dollars to AIG, newly elected President Rush Limbaugh instituted a national jobs training program for unemployed investment bankers, insurance execs, and rating agency analysts in an effort to support real estate prices in Manhattan and East Hampton which had fallen to 5% of their 2008 values and distributed gasoline coupons giving NY residents the right to buy gasoline for one year at the discounted price of $25 per gallon (50% off). Meanwhile AIG continued to hold its annual Lollapalooza Insurance Conference at Aspen Colorado. Invitees spend a day engaged in trust and morale building exercises. Mytee Vinegar organizes catering, Dean Pisch is in charge of the obstacle course relay race and I supervise the Shoshoni Indian totem pole climb. The event always gets a good write up in the Daily Underwriters Herald. The headline last year read, "Lollapalooza: It takes Pisch and Vinegar to Run Obstacle Course". I was not mentioned.

My name is Dan Lowman and I was Lowman on the totem pole.