Nassim Taleb on Black Monday, Fed, Market Lessons

let's begin if we can with the 19 yes rewind the tape okay where were you I was what we was doing the first I was at first Boston and I was an option trader and I was trading a lot of things more mainly fixed income options and currencies and currency options were extremely inexpensive at a time during that period for some weird reason particularly in for out of the money option for options that were remote so I had accumulated a few of these I also accumulated a very large amount of out of the money options in Treasuries and in short term fixed incomes for no other reason than they were much cheaper than I had seen in the past and I was happy buying there so I had a large portfolio of these and I was effectively short volatile early people don't fail to understand that I was I would have been harmed by small Lou you see I was set up to be harmed by a small move and gain if the move continues to something very large and and it was a very nice way to earn money if nothing happens lose money if something mild happens and of course make a lot of money if something huge happens and and that kind of position allows you to accumulate a lot of options in the tails so that day walking ahead I'm sorry about those hardly looking at stocks focusing on fixed income and then you had to remember during that period stock options were something very artisanal there was a very small market not that many people traded equity often because there was no money there there was no the quiddity no death fixed income up options on the other hand were huge we came out of a big deficit if you recall big inflation in the 70s and in the 80s you had so many bonds outstanding that was what you did when you wanted to trade if you went into equities it was you know because you couldn't probably couldn't get on earth they won't let you in on a fixed income floor so that was and we could trade in my department equity options but there was no big volume for us so it was an artisanal thing and later on when I became a bit trader I was taking a sabbatical it wasn't you Nobles to become an autism and have a nice little life you know working my own hours let's sort of like the uber driver of that business you see like a freelance trader and you realize that all freelance traders so in that space fixed income equity options so this is why there was no that there was no big we didn't hear big stories then fixed income was very large another thing you can remember that portfolios were very large at the time and it was options were driven mostly by big cover drives like some people selling calls nobody was interested in puts some options so the collapse happens and there was no big liquidity so the action was in currencies in fixed income now at what point during the day did you come to realize what was actually happening at no point well your trading is like in a battle you see so like when I'm on TV when you when I'm on TV I don't know during the episode what's going on it's later on that I realise you know what I said you see we were concentrating so like you're solving a math problem you don't know you don't know you're surrounded but I remember there was a state of heightened concentration I was 30 years younger it was 30 years ago so you can you're in a state of concentration all day and then eat knew something was going on but didn't think about it didn't think about these terms but you saw prices going down I saw prices going down and they kept going and people were panicking he keeps going and and someone came to me and and and made a remark he said don't they know that six Sigma's are something you don't observe more than once for a lifetime I said no the market doesn't know it and I remember that that was a joke the guy was visibly suffering and in his own portfolio and this is what I was concentrating it's very strange to these things when he concentrated for eight hours and my career I have had six or seven of these like when Saddam invaded Kuwait so I had to go to the office in like 2:00 a.m. and I remember of the state of concentration for about 1516 hours and and the nose I really think about the events in these terms till I took stock laters it's the same thing with with a stock market crash so when that moment came yes when you took stock of what had happened yes what went through your head I thought I was there's something in my guts that told me that what I was doing those rights because I had would series that people really didn't believe him at a time still people still don't believe in him but but now I don't care at a time I cared I was employed at first Boston and I was so my business was buying tail options out of the money options in and and waiting for a large event will happen and trying to survive try to survive in between that was my business at the time already okay I'm 30 years ago so here's this guy in this funnies you know it was maybe brash maybe confidence maybe you know less confident that I'm now whatever this guy it's hard to be taken seriously you see other than hey he's something you know some kid who was a bit with a big ego but after the event I knew that I was right and and and I knew that people take me seriously you knew that you'd also made a lot of money I made a lot of money and also knew that all this financial modeling everything you learn in class all this black Scholes option model is nonsense see I knew that because basically all they did is give you they focused on probabilities of a plane crashing and here you see how a plane is crashing at the same time right or a thousand planes crash so you realize that that's something there's something wrong in their model so I felt vindicated because I knew it was nonsense and it turned out to be nonsense so that was your proof effectively it was it felt but it's sort of like it was good because it convinced me so we feel the serenity and and fear at the same time I wanted you know the firm to survive I didn't want New York to be in trouble I had to had an apartment in New York I had you know had my money think so I wasn't really bulletproof black mint and green pant Greenspan's saved the system when he went and gave the money when he promised liquidity he gave liquidity he made sure that margins were covered made sure that the system the payment system that's probably the only thing he did right in his life right entire life from games back what would have happened had the Fed not stepped in on the twenty everything offering unlimited liquidity it would have been first of all it would have locked me in a financial system today but would have been a complete bloodbath then so let's think now it was calm perfect because there is a legacy to that this is exactly what I had for me shock responsibilities exactly so what happened then is that you have to remember one thing moral hazard moral hazard was had started in 1982 under of all people Reagan Ronald Reagan Ronald Reagan nationalized continental Illinois so he has a nationalized Bank continental Illinois has an option firm bought an option steering firm called first option of Chicago and they were so incompetent that they did not they netted exposure by traders not realizing that the trader who goes bust the trade of making money isn't gonna write him a check they were a clearinghouse they're not a trading house okay it's not a family okay so all these and and then of course so first option of Chicago went under sea Carnell Illinois and directly bailed out and you know what happened to it eventually emerged something else then we had we saw already that you could make a huge mistake if you're an institution and be saved if it's costly enough to the system individual traders went bust they went bust let's say still do they they're gone alright the and and and critically critically Greenspan thought that he had a magic wand all right move it you solve problems and he started his interest rate lowering scheme at a time as a knee-jerk reaction this of course he lowered interest rates four or five years later not even four five years ago three years later we had the RTC problem if you remember he lowered interest rates then dramatically the savings and loan crisis savings and loan crisis he bailed out the banks to remember and he helped perpetuate moral hazard that's eventually led to that crisis of nine years ago and we can't get out of it what did it feel like to you to come to this realization particularly at the end of October the 19th knowing that you were one of the few people who had figured out that there was this abnormal distribution I did the financial market events I didn't think of these terms I started calling friends to see if they're okay and effectively my cousin I mean you've got a time there was no cell phones so you go home and then you have like gourd fever it's not calling anybody you know to just chat about the events and and it can't leave the apartment because Hong Kong may call you know as something that happened so and I remember as I was talking to my cousin he said well there's a police downstairs it turned out some fellow committed suicide on 72nd and first on so so it tells you it was very close to home and but it's only after the event that I saw the panic sort of like one thing you learn from from accounts of Roman legions that when they got into battles they have no idea what they're doing this is automatic behavior the Train maximum concentration they don't think about anything until the battle is over then they realized hey you know what I'm injured so going into that day do you recall what the size of your positions was in nominal it was okay so to go back to the notion of nominal it makes no sense to talk nominal because I was accumulating a lot of tiny options I see tiny options and and I remember the P&L and today's terms would be for the firm I mean something substantial in today's turns but at a time you know it was not the same was not the same it was an intensive million mid tens of millions and in today's turns maybe 60 70 80 million in one day what for a trader just set up at a time it was a lot of money and for a guy like me had it first Boston treat you they treated me very well because what I mean very very well the problem is it was still a communist system where everybody had to share and everybody had lost money except for me and other fellow so so it was a of course we had some but at the same time they they treated me relatively you gotta remember that compensation at the time was nothing like today do you remember how much you got paid that year I can't talk about it I'm not gonna talk about it you could call up someone say what what pay off traders had but then but I I didn't catch it the first immediately it took me three years of bonuses to get the whole or pay off see better yes the and you recall how you how you traded in those intense moments of concentration how were you trading through the day yes 19th and the 20th I remember the 20th I get on a phone and I had set up you know so on and has a training assistant or so and get 15 phones and 200 screens it was not like today and and you're shouting our songs a direct line to the pit and direct line to Chicago fit on Philadelphia and one to the currency is one fixed income and then one and then talking the Board of Trade and I remember there was a fellow called Richard Dennis I don't know if you've heard of it he's one of the famous people it was famous at a time and he was bankrupt he went bankrupt that morning on the open is there was a trend in euro dollars a rally in euro dollars okay sorry the trend of rallying interest rates okay and the guy was short euro dollars I think one to his face and he lost his fun anytime was substantially $15,000,000 fun stuff like that so they were liquidating the thing and I remember I had a huge a delta and you're about right I remember then vividly offering something right on a phone and selling it considerably higher so the guy in a pit you know called Tim I tell Tim sell here and he'll tell higher so it was like in trading places have you seen that movie see got one I got one it was like that alright so all the morning me and so we expend the whole day all right liquidating but all morning I remember we were standing above our offers just one here one here one here I mean you want to take time to unload your inventory and sure enough there was liquidation and we got lifted on all our offers and then of course came back interest rate came back to 300 300 on a day or something so that was the first currencies went wild all right the dollar of course collapsed dollar yen options we had options we had bought for $10,000 and there is Authority they were selling for seventeen million something crazy again alright be and and the thing was going right it was like it was it was it was out of control so the big payoffs were in in not in the main big currencies but in the ones where the move was a big surprise like euro dollars or again Swiss franc had high volatility relative to others it wasn't as bad for participant in it why is that such why do you think that's such an untold part of the Black Monday story the action in Eurodollar futures the action and currencies because it's a professional market and the professionals don't I mean it's the largest market was fixed income at a time the largest market and currency food currencies but people only professionals talk about anything and these professionals involved at the time are dead like Monday everybody remembers what happened to IBM because they owned IBM but it's not the same scale yes plus there's another thing you're gonna talk about when you talk about the stock market it has a large inventory you see but the the turnover is nowhere near what we had in the fixed-income Black Monday has been described as your epiphany yeah how would you describe it no I mean I'm I don't want to talk about myself because I really I mean there's an effect of false memory what when you go back and I remember some scenes that were quite vivid but I remember that I did not expect the next day me would be gold Tuesday that's where you made more money yeah of course that was the big day for me is Tuesday because that's what what when the action of Greenspan we're vastly more momentous than when that happened and stuff like that you also have to remember that the stock market had high volatile relative to other things and not that many people played in complex instruments because of that volatility but yen for example didn't have a high volatility so it's fooled a lot of people the if I'm not mistaken talking about the equity market the VIX reached a peak on Black Monday that it has never seen since okay there was no fixed at a time right and and even the VIX I considered an artificial contraption its general so what I learned from like Monday was that number one of these things happen and and when they happen everything you make elsewhere disappears it took me another thirty years to figure out something I told you I was 29 years on on it was always here to explain that unless you're headed for a portfolio unless your head for events like like Monday whatever alpha you know you you think you're gonna get you're not gonna get it because what I call the ergodic problem because what happens is that if you go bust on that day there's no alpha and and most people don't realize that if you have to shrink your portfolio on things like that now since the Black Monday I mean I didn't really think about too much except that here I had some cash I realized it hit me after a while that I couldn't do something else in my life and trade see I was in my twenties it was time you know I could figure out what to do the problem is I like training a little too much see so particularly for these days where you feel deep in your guts that there's something you're doing right it's not the money so much although the minds like entertainment form of it makes it easy it was not it was just I like that so you learned some important lessons on Black Monday what what did everybody else not learn that these events are not outliers the regular part of the sister saying that that and there's a first mistake people made them like one day before Black Monday those who wanted to do risk management went to the past and look for the worst deviation and there was something like 10% so you had Black Monday now which was torn about 2.2 times whatever the deviation now what do they do when they back test to Black Monday don't you recurse so in the there was a new field I mean no field like 34 years old field and science called extreme value theory and started with Dutch wanted to build a you know to build to protect themselves how high should our protection so do we protect to the worst past of course not it's logical that it could get worse okay so he will take the worst past and you multiply it by one and a half or some factor and as you and you live if that's the case why is it that people still continue to use models like black Scholes because they don't pay for their losses someone else pays for the losses and plus if you're only gonna be wrong one day say and don't pay for your losses so it's fine in other words so long as losses are socialized so long as there is moral hazard people will continue to use these flawed risk management tools milassas don't have to be socialized they could be just transferred to the taxpayer and that's I mean to the shareholder like you work for a bank okay like the whale the whale got what bonuses 30 million-dollar bonuses here's before and then he lost six billion he didn't have to pay penny over six billion so I call it to the Bob Rubin train and you know you make a hundred million dollars over ten years and when a Black Swan event happens you say it was a certain you know nobody don't seen it that's it so it's very easy to use a regular model that predicts a regular that sort of like it's very easy to sell people a seatbelt that only works if there's no accident okay so it's gonna be comfortable and if there's an accident they're gonna die so they're not gonna complain all right so that's sort of the idea

Channel: Bloomberg Markets and Finance

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Length: 21min 52sec (1312 seconds)

Published: Mon Oct 16 2017