Greenspan…genius?

May 21 (Bloomberg) — Alan Greenspan, the former Federal Reserve chairman, has helped Pacific Investment Management Co. make “billions of dollars” in his role as a consultant, said Bill Gross, the bond manager’s co-chief investment officer.

During a 30-minute discussion on banks several months before the global credit crisis, Greenspan’s “brilliance in terms of forecasting the potential for exactly what happened was a big money saver for us,” Gross, who runs the world’s largest bond fund, said yesterday at a conference organized by the Asia Society in Los Angeles. “He’s made and saved billions of dollars for Pimco already.”

Ben S. Bernanke, Greenspan’s successor as head of the Fed, has slashed U.S. interest rates seven times since September, to 2 percent, to prevent a housing market collapse from dragging the world’s largest economy into recession. Treasuries gained from July through March, the longest rally since 2000, according to an index compiled by Merrill Lynch & Co., as investors sought the relative safety of government debt.

Greenspan cut the Fed’s benchmark interest rate to 1 percent in June 2003, the lowest since 1958, and kept it there for a year. He has recently come in for increased criticism for his handling of the economy and the housing bubble in the years leading up to his retirement from the Fed in 2006.

Laying Blame

House Financial Services Committee Chairman Barney Frank and former Fed Vice Chairman Alan Blinder have faulted Greenspan for lax oversight of mortgage lenders. Critics including Carnegie Mellon University professor Allan Meltzer blame the former Fed chairman for keeping interest rates too low for too long, fueling the surge in house prices.

“He bears some responsibility for the subprime problem,” said Yasutoshi Nagai, chief economist in Tokyo at Daiwa Securities SMBC Co., a unit of Japan’s second-largest brokerage. “If he had been faster to hike rates, it wouldn’t be so severe. The Fed is also responsible for banks, who lent to people who should not have been buying.”

Defaults of subprime mortgages in the U.S. have triggered a worldwide credit crunch, with banks and financial institutions facing more than $380 billion in writedowns and losses related to bad debt. The Merrill Lynch index has returned 6.6 percent since the Fed’s first cut on Sept. 18.

Since retiring as head of the Fed in January 2006 after 18 years, Greenspan, 82, signed on in May last year as consultant to Newport Beach, California-based Pimco, which manages more than $800 billion in assets. He is also an adviser to hedge-fund firm Paulson & Co.

Avoiding Housing Mess

Greenspan guided the U.S. economy through its longest expansion and became known for often-cryptic congressional testimony and phrases such as “irrational exuberance” that shook up global markets.

Gross, 64, anticipated the collapse of the U.S. housing market and the Fed’s subsequent interest-rate cuts. He shunned riskier corporate debt in 2006, a call that caused his fund to lag behind peers. Gross’s $128 billion Total Return Fund slipped as much as 4 percent in the first half of 2006.

The decision to sidestep subprime-linked debt has helped the fund surge 12 percent in the past year to beat 95 percent of its rivals, according to data compiled by Bloomberg.

Earlier this year, Gross started piling back into mortgage bonds to take advantage of slumping prices. In April, he lifted his holdings in mortgage-related debt to the highest since 2000, and lowered his stakes in U.S. Treasuries after calling them “overvalued.”

Going to Asia

As of April 30, Gross’s Total Return Fund held 65 percent in mortgage debt, according to data posted on the firm’s Web site. The fund also holds 6 percent of assets in emerging-market debt. This year, Gross’s Total Return Fund has returned 4.1 percent, beating 94 percent of peers, Bloomberg data show.

“You want to invest where the growth is,” Gross said yesterday. “The growth is in Asia and the growth is outside the United States.” To be invested in U.S. fixed income is to be “at a disadvantage twice,” he said.

Pimco is a unit of Munich-based insurer Allianz SE.

 

The Guv”

Well, I wrote about this a few months ago. Nice to see Bloomberg agree.

Ben Bernanke, the consensus-building academic who toiled in Alan Greenspan’s shadow, is emerging as the most powerful–and inventive–Federal Reserve chairman in the 95-year history of the central bank. Paul Volcker says he’s overreaching.

By Steve Matthews
Bloomberg Markets June 2008

The event was a 2002 conference at the University of Chicago to celebrate the Nobel laureate Milton Friedman’s 90th birthday. When Ben S. Bernanke rose to speak, he said that the Federal Reserve, of which he was then a governor, had come around to Friedman’s view that the central bank’s blunders were to blame for the Great Depression. “We’re very sorry,” Bernanke said, prompting laughter. “But thanks to you, we won’t do it again.”

Bernanke, a longtime scholar of the 1929-to-1933 panic, now has the unwelcome task of trying to keep a new financial calamity from turning into a full-blown depression. What started as a meltdown in the market for subprime mortgages has turned into a worldwide credit and economic crisis. Bernanke, now the Fed chairman, has responded with the most-aggressive expansion of the Fed’s power in its 95-year history. Since last August, Bernanke, 54, has twice cut interest rates by 75 basis points, made Federal Reserve loans available to investment firms for the first time since the 1930s, lowered the rates at which banks can borrow from the Fed and launched an unprecedented rescue of Bear Stearns Cos., the struggling investment bank. (A basis point is 0.01 percentage point.) To prevent a wider crisis, the Fed risked the U.S. government’s money by lending $29 billion backed by Bear’s risky mortgage-backed securities. The loan was an incentive to JPMorgan Chase & Co. to buy the 85-year-old bank. (See “The House of Dimon,” also in this issue.)

While Bernanke’s attack on the U.S. economic malaise has been fierce, friends say the Fed chairman himself is anything but. “He is very even keeled, with a pleasant demeanor, a level temperament,” says Richard Newell, an economist at Duke University who studied under Bernanke at Princeton. “He’s not inclined to hit one over the head with the depth of his knowledge–that makes him an effective communicator.”

Bernanke’s rate cuts were followed by the release on March 31 of a sweeping proposal by U.S. Treasury Secretary Henry Paulson to revamp government supervision and regulation of the financial system. Paulson endorsed the Fed’s moves to stabilize the economy and proposed the central bank be given a permanently expanded role as watchdog over the entire financial system, including commercial and investment banks, insurance companies, hedge funds and mutual funds. “The Fed would have the authority to go wherever in the system it thinks it needs to go for a deeper look to preserve stability,” Paulson told the press.

At a press briefing in Miami on April 7, Paulson said the plan–which would abolish the Securities and Exchange Commission–may take several years to implement, and the Democrats, who control Congress, say no quick action is likely. Even so, Bernanke’s Fed has already grabbed some of the power the Treasury proposes to give it by inserting itself into the back offices of the investment banks. “Since we’ve begun lending to dealers, including the remaining investment banks, we have put examiners on the ground in those firms, and we’ve established off-site teams that coordinate with them,” Bernanke told Congress’s Joint Economic Committee in testimony on April 2.

Bernanke, an academic from rural South Carolina, took office in February 2006 in the shadow of former Fed Chairman Alan Greenspan, who held sway at the central bank for 18 years. Bernanke, a Republican, is now well on his way to becoming the most powerful Fed chairman ever. “One interpretation of the Paulson report is that the Fed is handed any authority to do anything it wants,” says former Fed Governor Lyle Gramley, now a Washington-based senior economic adviser for Stanford Group Co., a wealth management firm in Houston. “It assigns the Fed overall responsibility for any financial institutions that might be a source of systemic risk.”

Former Fed Vice Chairman Alan Blinder says Bernanke’s actions are justified. Paulson and President George W. Bush have done little to address the mortgage crisis, he says. “The Fed has been extremely creative and is fighting this war almost exclusively by itself.”

The Bernanke Fed may have already seized too much power and has abandoned historical principles, says Paul Volcker, who was Fed chairman from 1979 to ‘87. “The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers,” Volcker, 80, told the Economic Club of New York on April 8. “A direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in times of crisis: lend freely at high rates against good collateral. It tests it to the point of no return.”

Bernanke says the gravity of the crisis is extraordinary. Until the beginning of this year, he had looked for consensus among his fellow Fed governors–a departure from the chairman-dominated regime of Greenspan, says Gramley. Then, in a Jan. 10 speech, he laid out a more dour view of the country’s economic prospects and promised to lower interest rates to address the unfolding credit crisis. The speech signaled that Bernanke was shaping policy rather than following the view of the group, Gramley says. “That was when Bernanke realized the idea of letting a consensus develop sounded good, but in times like we were going through now would no longer be effective. He put his foot down. That is what we have been seeing since then.”

Ben Bernanke, the son of a small-town drugstore owner, has been preparing his entire adult life for the fight against what Greenspan has called the “most wrenching” economic crisis since World War II. A former Princeton University economics professor who was appointed to a four-year term as Fed chairman and 14-year term as a Fed governor by Bush in 2005, Bernanke has been studying the causes of the Great Depression since he was a graduate student at Massachusetts Institute of Technology.

In 1989, he wrote an article with Mark Gertler, a New York University economics professor, for the American Economic Review in which they presented a detailed model that helps to explain the cascade of events that led to the collapse of markets in the years after the 1929 crash. The research showed for the first time that, in a financial crunch, as borrowers’ net worth declines, their financing costs increase. That brings about an “accelerator effect” that can make a downturn more severe. Since it was published, the research has been cited about 400 times in other economics journal articles, says Gertler.

A weakening of borrowers’ balance sheets results in further credit tightening, creating a vicious circle, Bernanke wrote. That process, he told the House Financial Services Committee on Feb. 27, is behind the continuing credit crisis today. “There’s an interaction between the economy and the financial system, and perhaps even more enhanced now than usual, in that the credit conditions in the financial markets are creating some restraint on growth,” he said.

Bernanke’s approach to the current financial troubles has been shaped by his scholarship, says Gertler, 57. “The Fed let financial markets go, and that caused the depth and duration of the Depression,” Gertler says. “He has taken that conviction to heart. There is no one on this planet who has a better understanding of financial crises, and better intuition, and that is what is driving Fed action.” In 2000, Bernanke published a book, Essays on the Great Depression, the introduction to which includes this statement: “To understand the Great Depression is the Holy Grail of macroeconomics.” Princeton University Press initially printed 1,500 copies of the 320-page tome; it has since gone through five additional printings and sold a total of 6,500 copies. By contrast, Greenspan’s book The Age of Turbulence: Adventures in a New World had sold 488,000 copies as of March 30, according to Nielsen BookScan.

Lee Hoskins, who was president of the Cleveland Federal Reserve, one of 12 Federal Reserve banks, from 1987 to ‘91, says Bernanke has been ill served by his preoccupation with the Depression. “The Fed has shown a hint of panic,” Hoskins, 67, says. “The solution should not be to bail out institutions or run around with all sorts of new programs. The Fed is overreacting to fears.”

Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh, agrees that Bernanke is swatting a fly with a sledgehammer. “In monetary policy, he has not been good,” Meltzer, 80, says. “It is a silly policy designed to head off a recession that may come but hasn’t come yet.”

Meltzer says the Fed, by ignoring the inflationary potential in its latest rate cuts, is creating the possibility of negative real interest rates. He also says the Fed should never take credit risks, especially to save floundering banks. “We can’t have a system that continues to work well if the bankers make the profits and the public, the taxpayers, take the losses,” he says. “That is not a viable system.”

Meltzer says Paulson’s plan for expanded Fed oversight of the financial industry is both overreaching and impractical. “It’s hard to see how the Fed is going to do it,” he says. “The Fed’s record of anticipating and heading off crises is poor. Now they are going to go out and examine investment bank portfolios? Most of the people who are buying and selling this stuff don’t fully understand it. How is some Fed auditor going to figure it out?”

Former Fed Governor Gramley says the Fed chairman knows what he’s doing. “The innovativeness of the Bernanke Fed has no precedent,” he says. “Bernanke understands the implications of having credit markets seize up. He is well aware the Fed has to be as aggressive as possible.”

Gramley is one of a band of Bernanke loyalists who have followed his career from Princeton to the Fed, to the White House, where he served as head of the Council of Economic Advisers from June 2005 to January ‘06, and back to the Fed. “From my work with him, I know that he’s exceptionally levelheaded,” says Mark Watson, who was associate chairman of the Princeton economics department when Bernanke was chairman. “He was always able to keep his cool dealing with crises here at Princeton, even when others, like me, were going crazy.”

That quality carried over to the White House, says John Anderson, who worked with him there. “He was an incredibly quick study,” says Anderson, now an economics professor at the University of Nebraska-Lincoln. “It didn’t matter what the policy issue was. He was easygoing, easy to communicate with. He had a lot of credibility in the West Wing, with the president.”

Bernanke was thinking in terms of his Depression scholarship as early as June 2007, though it was not yet clear how quickly the mortgage meltdown would ripple through the broader economy. In a speech at an Atlanta Fed conference, he said both the failure of banks and declining creditworthiness of borrowers played a role in the Depression. And he added that last year’s decline in home prices could have a greater impact than expected. “If the financial accelerator hypothesis is correct, changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect, because changes in homeowners’ net worth also affect their external finance premiums and thus their costs of credit,” Bernanke said.

Bernanke and other Fed governors also discussed the notion of a chain-reaction financial crisis at meetings of the Federal Open Market Committee, which sets interest rates, in December 2007 and January and March 2008, according to minutes of those meetings. “Several participants noted that the problems of declining asset values, credit losses and strained financial market conditions could be quite persistent, restraining credit availability and thus economic activity for a time and having the potential subsequently to delay and damp economic recovery,” according to the minutes of the March 18 meeting.

From Bernanke’s standpoint, there are two major lessons to be learned from the Fed’s reaction to the market crash of 1929 that are relevant today. The first is that the Fed should lower rates, not raise them, in the face of an economic contraction. The second is that the Fed must pay careful attention to the health of financial institutions, as lending plays a big role in economic growth.

In July 1928, when financial markets were still booming, the Fed raised its benchmark interest rates to 5 percent, the highest since 1921, effectively cutting the money supply, in order to reduce what it saw as excess speculation on Wall Street. It did so even though there were no signs of inflation, Bernanke said at the conference honoring Friedman. In October 1931, after the market crashed and GDP had begun to nosedive, the Fed raised rates again to prevent the dollar from falling in international markets. That made it harder for companies and individuals to borrow even as the economy was contracting 30 percent and deflation was setting in. A series of bank failures further reduced credit throughout the economy.

While the United States moved to protect the dollar, the Bank of England, faced with depleted gold reserves backing the pound, in 1931 let the value of the currency float freely. The decision to abandon the gold standard allowed Britain and the Scandinavian countries to recover from the Depression earlier than the rest of Europe.

All of this is front-of-mind for the current Fed chairman, who is weighing the falling U.S. dollar among the factors he considers in making policy decisions. “We will address financial issues and try to maintain the integrity and stability of the financial system,” Bernanke told the Joint Economic Committee of Congress on April 2. “We will not let prices fall at 10 percent a year. We will act to keep the economy growing and stable.”

Bernanke started his term in February 2006 by trying to stamp out some of the growth in an overheated economy. Following Greenspan’s example, he raised interest rates three times, on March 28, May 10 and June 29, to counter a threat of inflation. By the time the credit meltdown began in July and August, the federal funds rate was at 5.25 percent, a six-year high.

Bernanke at first resisted pressure from Wall Street and the housing industry to begin ratcheting rates down. Instead, on Aug. 17, 2007, he reduced the discount rate at which the Fed makes loans to banks by half a percentage point and extended the maximum term of such loans to 30 days from overnight. By September, though, it was clear to Bernanke and his backers at the Fed that more-dramatic action was necessary. The Fed then took a series of actions:

• On Sept. 18, the Fed cut interest rates half a percentage point, the first of six cuts that moved the rate to 2.25 percent in mid-March from 5.25 percent in August. When the central bank reduced rates 75 basis points on March 18, Dallas Fed President Richard W. Fisher and Philadelphia Fed President Charles Plosser dissented, saying they preferred “less-aggressive action.”

• On Dec. 12, the Fed created the Term Auction Facility, a new lending vehicle to make 28-day credit available to banks as an alternative to direct borrowing at the Fed’s discount rate, which may carry a stigma. The U.S. also moved to increase the supply of dollars in Europe. The action was coordinated with the European Central Bank and three other central banks in the biggest act of international economic cooperation since the Sept. 11 terrorist attacks.

• On March 11, through the Term Securities Lending Facility, the Fed for the first time loaned Treasuries in exchange for debt that includes mortgage-backed securities.

• On March 16, the Fed cut the rate on direct loans to commercial banks to 3.25 percent and opened up borrowing at the same rate to nonbank securities firms. The move, taken on a Sunday, represented the Fed’s first weekend change in borrowing costs since 1979, when former Chairman Volcker was fighting inflation.

• On that same Sunday, the central bank announced its unprecedented arrangement with JPMorgan to take control of a collapsing Bear Stearns. In his testimony on April 2, Bernanke said that Bear Stearns advised it on Thursday, March 13, that without additional financing it would be forced to declare bankruptcy on Friday, March 14. The Fed announced the deal to let JPMorgan buy the bank on Sunday. “Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain,” Bernanke said.

In helping finance JPMorgan’s purchase of Bear Stearns and its mortgage-backed securities, the Fed for the first time created the possibility that taxpayers will take significant losses from a Fed action. “I don’t think there is anybody at the Fed who wanted to do that,” says William Isaac, a former Federal Deposit Insurance Corp. chairman, who led the FDIC takeover of the failing Continental Illinois National Bank & Trust Co. in 1984. “Sometimes you do things you don’t want to do. We had to stop the contagion.”

The U.S. Senate Finance and Banking committees are reviewing the taxpayer-backed sale. “You have a lot of smart people working at the Federal Reserve,” Republican Senator Sam Brownback of Kansas told Bernanke at the April 2 hearing. “I am concerned when the taxpayers’ money becomes the skin in the game to rescue supposedly sophisticated investment and commercial banks from the results of their own poor decision making.”

In his April 2 testimony, Bernanke pointed out that the Federal Reserve was created in 1913 in response to another market meltdown, the Panic of 1907. On March 14 of that year, exactly 101 years before the Fed’s Bear Stearns intervention, the stock market fell 8.3 percent, touching off a number of bank failures. Financier John Pierpont Morgan, who founded what later became J.P. Morgan & Co. in 1871, helped to save the day by calling together the heads of the largest U.S. banks and locking them in a room until they agreed to supply financial backing to the Trust Company of America, which was threatened with bankruptcy.

One cause of the panic was a depleted money supply. “There was a state of credit anorexia–what we would call a credit crunch today,” says Sean Carr, co-author of The Panic of 1907: Lessons Learned from the Market’s Perfect Storm (John Wiley & Sons, 2007). The Fed was created to serve as a lender of last resort in times of crisis and to monitor and stabilize currency markets through manipulation of interest rates.

The Fed has had just six chairmen since 1951: William McChesney Martin, who served for almost 20 years, Arthur F. Burns, G. William Miller, Volcker, Greenspan and Bernanke. The 6-foot-7-inch Volcker is best known for his successful battle against the high inflation of Jimmy Carter’s and Ronald Reagan’s presidencies. The consumer price index rose 14.8 percent for the year ended on March 31, 1980. Volcker’s Fed responded by raising the fed funds rate as high as 20 percent. By July 1983, inflation had been reduced to a tame 2.5 percent.

During Greenspan’s 18 years in charge of the Fed, the U.S. endured only two recessions, both lasting less than a year, and enjoyed the longest economic expansion in U.S. history. “He has a legitimate claim to being the greatest central banker who ever lived,” wrote Princeton economist Blinder, who spent 19 months as the Fed’s No. 2 in the mid-1990s, in a paper presented in August 2005 at a Fed conference devoted to the “Greenspan Era.”

Greenspan had been Fed chairman for just a few months when he faced his biggest challenge, the stock market crash of Oct. 19, 1987. The Dow Jones Industrial Average plunged 23 percent that day amid concern that a falling U.S. dollar could lead to Fed tightening. The decline was worsened by failed trading strategies among financial firms and resulting margin calls. Greenspan responded by pumping money into the banking system. The economic expansion continued. Greenspan built a reputation as a man who could navigate crises: He put off a planned rise in interest rates after the Asian currency crisis of 1997. He cut rates following the Russian debt default in 1998. And he helped pull together a bailout plan after the failure of a big hedge fund, Long-Term Capital Management LP, that same year, threatened to trigger a broader crisis.

Critics say Greenspan was also partly responsible for speculative bubbles, first in tech and Internet stocks in the late ’90s, then in housing prices. The housing bubble swelled as Greenspan kept the fed funds rate at 1 percent in 2003 and ‘04. “One of the reasons we are in this particular predicament is because for 20 years the Fed has been trying to suppress the downside of the business cycle and has been proposing bailouts and easing money whenever money needed easing,” says William Fleckenstein, president of Fleckenstein Capital Inc. in Seattle, Washington, and co-author of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve. Greenspan, in a Financial Times commentary on April 6, said low long-term interest rates, rather than the Fed’s manipulation of short- term rates, were the cause of the housing speculation.

Bernanke, with his sharp interest rate cuts and rescue of Bear Stearns, has kept up the Greenspan practice of intervening to stimulate economic activity. Such emergency action would not be necessary if Fed governors, including Bernanke, had had more foresight, says former Fed Governor Martha Seger, a Reagan appointee who served from 1984 to ‘91. “In general, the Fed is very late to get onto things, and by that time, it’s a full-fledged roaring disaster about to happen,” Seger says. “The Fed is prone to ignore problems as they’re building up, and by then you not only get the fire trucks but ambulances and everything else.”

Bernanke has seen poverty close up. Born in Augusta, Georgia, in December 1953, he grew up in Dillon, South Carolina, a textile-and-farm town in an especially poor part of one of the U.S.’s poorest states. His father, Philip, owned a drugstore with his uncle; his mother, Edna, was a schoolteacher. The Bernankes were among the few Jewish families in the area.

Bernanke developed an interest in mathematics and economics at an early age. Calculus wasn’t offered at Dillon High School, so Bernanke learned it on his own, his uncle Mort Bernanke, 79, says. Bernanke played saxophone in the high school band and was an above-average talent, says band mate John Braddy, who still lives in Dillon (population, 6,800). In 1966, the Fed chief appeared at Dillon High in a four-boy band called Fancy Pants in which all wore plaid trousers, according to the Dillon Herald. Later, he and Braddy played in a nameless rock band that belted out The Doors’ “Light My Fire” on the talent show of a local TV station. “We probably butchered it to the point it wasn’t recognizable,” Braddy says. Bernanke has since given up playing the sax.

Bernanke was the winner of the state spelling bee in 1965 and the valedictorian of his senior class. In 1971, he went off to Harvard, in Cambridge, Massachusetts, after scoring 1590 out of 1600 on his SAT exam. He used the proceeds of a $1,000 National Merit Scholarship to help pay his tuition. “You knew Ben was smart, but he never intimidated you or made you feel he was different than anyone,” says Braddy. During college breaks, Bernanke worked six days a week at South of the Border, a village of souvenir shops along I-95 near Dillon.

The Fed chairman earned a bachelor’s degree in economics at Harvard in 1975, winning the Allyn Young Prize for best Harvard undergraduate economics thesis. (It was called “An Integrated Model for Energy Policy.”) He then went on to MIT, where he earned a Ph.D. in economics in 1979. “He was the smartest guy in our class, and it wasn’t a class of dumb people,” says Alexander S. Kelso Jr., principal of Great Oak Development, a New Orleans- and Boston-based property development firm, who shared an MIT office with Bernanke.

“Ben was quiet and serious,” says Robert Solow, 83, an economics professor at MIT and Bernanke adviser who won the Nobel Memorial Prize in Economic Sciences in 1987. “I don’t think you got to appreciate Ben until you read his exam or talked to him one-on-one.”

Bernanke taught economics at Stanford University and New York University before taking a tenured professorship at Princeton in 1985.

Bernanke’s ascension to head of the world’s most important central bank has not changed him, says his Uncle Mort. “I’m sure Ben is under pressure now, but he never shows it,” his uncle says. Bernanke visited his parents, who now live in Charlotte, North Carolina, in March, and the family attended a Harlem Globetrotters game. “He seemed very relaxed,” says Mort Bernanke. “He has a sense of humor–a wry sense of humor, not boisterous.”

Bernanke’s demeanor has been a factor in the way he runs the Federal Reserve system. Under Greenspan , the FOMC, which sets interest rates, had been dominated by the chairman, according to Vincent Reinhart, who was the Fed’s chief monetary-policy strategist from 2001 until September 2007. Bernanke has made the FOMC a more democratic group, with more decisions made by consensus. He has extended the length of meetings, scheduling four two-day meetings a year, to allow for more discussion, Reinhart says. His speeches and testimony reflect committee forecasts rather than his personal views. He doubled the number of forecasts by the FOMC as a whole to four a year.

“It is an important point that Bernanke is trying to depersonalize monetary policy, which is an unselfish act,” says Reinhart, now a scholar at the American Enterprise Institute in Washington. “In terms of style, Alan Greenspan came from the corporate world, where he had been a director of many boards. He viewed the Fed chairmanship from that corporate perspective, which is formal. Ben Bernanke came from academia, where he had been chairman of the Princeton economics department. That’s much less formal and involves frequent give-and-take.”

There has been less of that give-and-take since March 18, when the Dallas Fed’s Fisher and Philadelphia’s Plosser registered their unusual dissent from the Fed’s latest rate cut. William Niskanen, chairman of the libertarian Cato Institute and a former member of Reagan’s Council of Economic Advisers, says that Bernanke’s dramatic lowering of interest rates will have unintended consequences. “The actions people take in difficult times tend to be what creates the next bubble,” Niskanen says. “This is a very dangerous situation.”

Equally dangerous was Bernanke’s rescue of Bear Stearns, says Seger. “I hate to say this, but this is sort of typical for the Fed,” she says. “It has this New York, Wall Street bias. They get special treatment.”

Bernanke denied any such bias in his April 3 testimony before Congress. “The issues raised extended well beyond the fate of one company,” he said. “The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence.” Having moved out of the shadow of Greenspan, Bernanke is improvising, trying to find a formula–even in the face of criticism by Volcker and others–that will ease the financial system out of danger and prevent history from repeating itself.

 

Berkshire Hathaway AGM

“I think the Fed did the right thing in stepping in on Bear Stearns,” Buffett said at the annual meeting of his Berkshire Hathaway Inc insurance and investment company. “Just imagine the thousands of counterparties around the world having to undo contracts.”

Buffett said a record 31,000 shareholders attended the meeting in Omaha’s Qwest Center, including an overflow crowd in halls outside the main arena.

He and Berkshire Vice Chairman Charlie Munger fielded questions for five hours, often humorously, on investing, the economy, politics and life.

Attendance has soared since Berkshire in 1996 created Class B shares worth 1/30th of a Class A share. These made it easier for ordinary investors to invest with Buffett, the world’s richest person.

RISK AT ISSUE

Buffett said the Bear debacle illustrates how some investment banks and commercial banks may have grown too large to effectively manage risk.

“The big investment banks, a number of them, and big commercial banks, I think they’re almost too big to manage effectively from a risk standpoint in the way they’ve elected to conduct their business,” he said. “You need someone at the top whose DNA is very, very much programmed against risk.”

Berkshire is, he said. “We want to run Berkshire where if the world isn’t working tomorrow the way it is working today, or in a way that wasn’t expected, we wouldn’t have a problem,” Buffett said. “If we can earn a decent return on capital, what’s an extra percentage point?”

One area of concern is the estimated $60 trillion market for credit default swaps, an insurance contract that covers losses to banks and bondholders when companies don’t pay their debts, and lets investors bet on credit markets.

Yet Buffett doesn’t foresee a collapse. “I don’t think it’s going to happen, and I think the chances of it happening were reduced significantly by the fact the Fed stepped in at Bear Stearns,” he said.

Berkshire, however, has benefited from market disruptions, including many triggered by the nation’s housing crisis.

Buffett said his four-month-old bond insurer, Berkshire Hathaway Assurance Corp, wrote $400 million in business in the first quarter, more perhaps than other rivals combined.

Much, he said, came from customers who already had insurance from other “triple-A” rated insurers, some of which got caught with exposure to subprime mortgages.

“It tells you something about the meaning of ‘triple-A’ in the bond insurance field in the first quarter,” Buffett said.

Buffett said Berkshire also bought $4 billion in “auction-rate” municipal debt whose yields soared, often into double digits, despite many issuers’ high credit quality.

SUCCESSION ON TRACK; BUFFETT EYES EUROPE

Buffett, 77, said Berkshire still has three internal candidates to eventually succeed him as chief executive, and four candidates to become chief investment officer. Berkshire ended March with about $147 billion in stocks, bonds and cash.

But noting that the average age between he and Munger is 80, and assuming they’ll live to be 100, Buffett joked: “We’re only aging at 1-1/4 percent a year. Some companies’ (CEOs) are aging at 2 percent. Think about how risky that is.”

Buffett plans this month to visit four European countries to seek out family-owned businesses he might want to buy when the time comes for a sale. He said Berkshire isn’t on the “radar screen” of many potential sellers in Europe.

Berkshire does have a process in place to make its 95 percent-owned German reinsurance unit, Cologne Re, a fully owned subsidiary “before too long,” Buffett said.

Buffett occasionally addressed more controversial issues.

Asked whether he should push Coca-Cola Co to pull back from its role as a big corporate supporter of the Summer Olympics in Beijing, Buffett said it would be a “terrible mistake” not to back the Olympic movement. Berkshire ended 2007 with an 8.6 percent stake in Coca-Cola.

And Buffett turned back efforts by American Indian tribes and salmon fishermen to have Berkshire’s PacifiCorp unit remove four dams on the Klamath River in California and Oregon, which they say kill fish. Three people asked Buffett questions about it and protesters occasionally shouted opposition to the dams.

Berkshire Hathaway chairman and CEO Warren Buffett and vice chairman Charlie Munger spent more than five hours Saturday answering questions from shareholders.

Here is a sample of their wit and wisdom on a variety of topics:

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THE OLYMPICS

Neither Buffett nor Munger thought it would be a good idea to use this summer’s Olympic games to penalize China.

“I think it’s very hard to rate a couple hundred countries that are participating on their behavior,” Buffett said.

Berkshire owns a sizable stake in the Coca-Cola Co., which is a major sponsor of the Olympics.

“I think the more people that participate in them, the better,” Buffett said.

Munger said he thinks the most important question is whether China has been improving in recent years. “The answer is, China is moving in the right direction,” Munger said.

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CREDIT DEFAULT

Buffett said he doesn’t think the roughly $60 trillion market for credit default swap derivatives will implode like subprime mortgage funds, although the number of defaults is likely to increase.

Those credit default derivatives are essentially an insurance policy on the chance that a company will go bankrupt.

Munger said that there could be problems with those derivatives, but that it likely won’t be nearly as bad as the subprime mortgage mess.

“I think the stupidity — while it’s extreme — is not quite as bad as sweeping bums off skid row to give them a house,” Munger said.

The Federal Reserve’s bailout of Bear Stearns reduced the chances of widespread problems with the credit derivatives, Buffett said.

Berkshire has written some of those credit-default derivatives and accepted $2.9 billion in premiums.

“I think we’re going to make significant money, although we can lose money, too,” Buffett said.

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SECURITIES

The recent credit crunch that has created turmoil in financial markets has also created opportunities.

Buffett said Berkshire has invested about $4 billion in auction rate securities because the interest rates those bond funds offered became attractive. Buffett offered one example of a municipal bond fund that offered 3.5 percent interest one week and 8 percent the next as the market was disrupted.

“This happened with billions and billions and billions of securities,” Buffett said.

The $330 billion auction rate securities market used to offer investors the chance to buy and sell long-term bonds frequently, because the interest paid on the bonds was reset every seven, 28 or 35 days.

But investors began fleeing late last year as the credit crunch intensified, and investment banks, in turn, starting backing away from their promise to buy the bonds at auctions.

That caused many auctions to technically fail.

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HEALTH

Neither Buffett or Munger are likely to win a doctor’s endorsement of their health advice.

Buffett, 77, took a bite of candy from the box in front of him, and then recommended a balanced diet of See’s Candy, Wrigley’s gum and Coke products. Berkshire owns See’s and a large stake in Coke, and it will soon own part of Wrigley.

Munger, 84, said he and Buffett ignore every health rule out there.

“It seems to have worked for us,” Munger said. “I don’t think we could recommend it for everybody, but I, for one, don’t plan to change.”

 

Buffett…

From a combination of two articles from the FT & Morningstar;

Warren Buffett is turning his attention to Europe, a continent he has hitherto avoided, writes Richard Milne in Frankfurt. He will start a four-country tour on May 19 in Frankfurt before going on to Lausanne, Madrid and Milan.

His goal is to examine the hidden secret of European capitalism: the family-owned companies that dominate the economies of regions such as northern Italy and Germany. People involved in his trip say he will meet some of the biggest such companies in each country, all of which are market leaders in their field.

The impetus for the tour comes from his recent acquisition of Iscar, an Israeli manufacturing company that was his first major purchase abroad. Flush with cash, Mr Buffett could find many companies in Europe that meet his criteria of being understandable businesses in long-term industries. He will also take part in several events focusing on family businesses with the IMD business school.

Family-owned companies across Europe are renowned for their long-term outlook and often have a much stronger export focus than their US rivals. But many have succession problems – and that is where Mr Buffett and his cash may well come in handy.

Warren Buffett’s investing prowess is now legendary: From 1965 through 2007, Berkshire Hathaways book value has compounded 21.1% annually. That showing more than doubles the S&P 500 Index’s pretax annual return of 10.3% over the same time period. It’s no wonder that a number of mutual fund managers have adopted his approach.

A Simple Strategy
So what does it mean to invest like Buffett? He looks for four main features in a company: a business he understands, strong long-term potential in a steady industry, trustworthy and proven management, and a reasonable stock price with a margin of safety. Buffett places emphasis on long-term competitive advantages–he calls them “moats”–that help firms prevail over rivals. For example, he says that Coca Cola’s edge is its global brand. Overall, Buffett focuses on owning well-run businesses within his realm of competence over a long time horizon.

While Buffett’s approach is straightforward, implementing it is another story. It requires patience and the ability to resist getting caught up in trends–scarce attributes in stock markets. He avoided technology stocks during the technology boom of the late 1990s, for example. Buffett has said he didn’t understand the sector well enough and also didn’t think technology firms’ competitive advantages were sustainable because the industry requires continuous innovation. In addition, he couldn’t predict tech companies’ future cash flows. Some questioned his approach during that time period; Berkshire’s book value gained only 0.5% while the S&P 500 returned 21% in 1999. He was vindicated, though, when the tech bubble burst in March 2000, and his strategy has clearly paid off over the long haul.

“Buffettologists”
While many mutual fund portfolio managers admire Buffett, some have wholeheartedly adopted his strategy. That doesn’t necessarily mean a carbon copy of Buffett’s portfolio (or returns), but in many cases, these funds’ discipleship has been a plus for their shareholders. Below are some of our favorite Buffett followers.

Fairholme Fund is a Fund Analyst Pick that has gained an annualized 16.32% since its late-December 1999 inception. Investors here get exposure to Buffett directly, through his own conglomerate, Berkshire Hathaway which soaked up 18.42% of the fund’s assets as of Nov. 30, 2007. Like Buffett, managers Bruce Berkowitz, Larry Pitkowsky, and Keith Trauner concentrate the portfolio; they currently own just 19 stocks. Another Buffett characteristic: They fancy insurance stocks, because consumers purchase insurance repeatedly and, they argue, insurance is a necessity. But unlike Buffett, they invest in energy stocks, an area that is often seen as unpredictable and opaque because of its macroeconomic drivers. However, Fairholme’s managers find some energy firms compelling, due to fundamental traits that exist regardless of the direction of commodity prices, such as management quality.

Sequoia Fund which reopened to all investors on May 1, 2008, after being closed for 25 years and which we have recently added as a Fund Analyst Pick, is another Buffett-like option. (For more on Sequoia’s reopening, see senior fund analyst Mike Breen’s recent video report.) Like Fairholme, comanagers Bob Goldfarb and David Poppe invest a large portion of the fund’s assets (24.75%) in Berkshire Hathaway, and also run a concentrated portfolio (25 stocks). The team invests for the long term–often keeping turnover in the single digits and teens–and looks for firms with qualities such as management’s ability and competitive edge. Goldfarb and Poppe also stay away from cyclical sectors such as technology and energy, preferring to stick with more-consistent growers. However, Goldfarb and Poppe aren’t as valuation conscious. He’s willing to buy stocks that don’t look cheap if he believes that they can deliver high returns relative to the company’s capital. This approach has proven its worth here; it’s led the fund to gain a whopping 15.19% on average each year since its mid-July 1970 inception.

Weitz Value, Manager Wally Weitz’s extreme contrarianism distinguishes this fund. He’s happy to invest heavily in downtrodden stocks, as long as he thinks there is long-term promise. For example, he started buying housing-related stocks, such as building materials maker USG and added to financials in 2007, even as those areas were crushed as the subprime crisis began to unfold. As a result of this practice, this fund can look beaten-down for extended periods; its 6.5% annualized five-year gain is weak. But Weitz’s bets have paid off over the long run, returning an annual average of 11.42% since its May 1986 inception.

Legg Mason Growth, run by Robert Hagstrom, a longtime Buffett follower who has written books on Buffett’s approach. This fund has returned 9.83% on average per year since its April 1995 inception. Here, while the fund’s roots are in Buffett’s value-oriented discipline, its approach has evolved over the years–more so than at other Buffettologist funds. While Hagstrom still looks for stocks with strong long-term prospects and runs a concentrated portfolio, he ventures into areas that Buffett shuns–in particular, technology highfliers such as Yahoo. Thus, the fund’s valuation multiples are higher than many of its Buffett-like peers’, making it sensitive to price risk.

Pass on this Poser
It’s worth pointing out that not all Buffett-like funds use the same approach. At Wisdom, manager Douglas Davenport wants to give investors more accessible exposure to Buffett’s portfolio. He believes that Berkshire Hathaway’s stock price is artificially high because of Buffett’s reputation (Berkshire’s B shares closed at $4271 on April 28, 2008). Instead, he seeks to mimic Berkshire Hathaway’s portfolio by holding the same publicly traded companies and firms similar to Berkshire’s privately held ones.

We have a couple of issues with this strategy. First, Davenport doesn’t have inside information, so he finds out about Buffett’s moves when the public does. Thus, once he buys the stock, there’s the risk that its price is already bid up because of the time lag and the publicity surrounding Buffett’s purchase. Second, because he cannot hold Buffett’s privately held companies, he spends most of his time looking for suitable proxies, such as replacing See’s Candies with Wrigley (which could soon turn to cash if privately held Mars, helped by financing from Buffett, takes over the company). These substitutions aren’t perfect and sometimes he makes multiple investments to simulate one private firm, which results in a less concentrated portfolio. Overall, this approach has not paid off–the fund has gained a measly 4.37% on average annually over the fund’s nine-year lifetime.

Buffett vs. Buffettologist?
Of course, Buffett fans could just buy either an A share of Berkshire Hathaway–which also gets you a ticket to the annual “Woodstock of Capitalism,” one of the most well-attended annual shareholder meetings in the world. But we think the Buffett-like funds have some advantages for many investors.

For starters, Davenport could be on the right track about one thing–Berkshire’s stock price and movements don’t perfectly replicate Buffett’s investment performance. Other factors that affect the stock include speculation surrounding Buffett’s succession plans and press releases about potential acquisitions (such as this week’s announcement of the firm’s involvement in the Mars-Wrigley deal). Thus, we think investors will experience unnecessary stock movements that aren’t a result of Buffett’s portfolio.

We also find the funds’ entry points much more reasonable for regular folks–most require a $2,500 minimum, and you need only $1,000 to buy Legg Mason Growth. In contrast, you need more than $120,000 to buy one A share (Buffett doesn’t believe in stock splits) and $4,000 to buy a B share of Berkshire.

The big question, though, is performance. Which asset has given you more return? The results of the funds are admittedly mixed when pitted against the stock, but they don’t differ by more than a couple percentage points (with the exception of Legg Mason Growth, which has suffered recently for its complete lack of energy stocks–the best performing sector over the past 12 months). And notably, over its short lifetime, Fairholme has beaten the stock’s performance by more than 5 percentage points.

As to future performance, there are no guarantees. True, it is easy to bet on Buffett for the long haul, and despite imperfections, Berkshire Hathaway stock does give investors the most undiluted dose of Buffett’s genius. That said, his disciples are certainly no slouches. Indeed, our favorites cited here boast long-term performance records superior to those of their peers and we’re quite confident in recommending any one of them to long-term investors.

 

I want to be a “hedgie”

And the latest 2007 salaries [winnings]

John Paulson (Paulson & Co.) — 2007 earnings: $3.7 billion. Beginning in 2005, Paulson made huge bets on the decline in value of securities backed by subprime mortgages

George Soros (Soros Fund Management) — 2007 earnings: $2.9 billion. Soros’ $17 billion flagship Quantum Endowment fund racked up a 31.7% return in 2007, its best annual showing since the high-tech implosion at the start of this decade. Soros’ $2.9 billion payday comes almost entirely from his personal stake in the fund (which he no longer manages). I don’t know how he made that 31.7% return.

James Simons (Renaissance Technology) — 2007 earnings: $2.8 billion. Simons, a mathematician and former Defense Department code breaker, uses complex computer models to trade.

Philip Falcone (Harbinger Capital Partners) — 2007 earnings: $1.7 billion. Like Paulson, Falcone placed a winning bet against the mortgage market. He pulled in returns of 117% after fees in 2007.

Kenneth Griffin (Citadel Investment Corp.) — 2007 earnings: $1.5 billion. Griffin manages $20 billion and is a big information technology innovator that trades derivatives. equity securities. and listed options and buys distressed assets at a discount. For example, In late 2007 a Citadel-led group put $2.55 billion into struggling E*Trade Financial Corp., (NASDAQ: ETFC), the U.S.’s fourth-largest discount brokerage.

 

The Black Swan

March 27 (Bloomberg) — On a freezing day in March 2007, Nassim Taleb walked into a conference room at Morgan Stanley’s Manhattan offices on 47th Street and Broadway to address a group of the firm’s risk managers. His message: Your models don’t work.

Using a whiteboard to scribble out his calculations, Taleb, now 48, began one of his rants, this time against stress tests — Wall Street lingo for examining how a market rout will play out. Stress tests are inherently risky because they ignore rare but potentially devastating events, Taleb said.

“Past shortfall doesn’t predict future shortfall,” the options trader turned best-selling author recalls telling the assembled group of about 40. The risk managers, part of a tribe of mathematical model makers known in the finance world as quants, stared back at him blankly, and a debate ensued, according to people who were there.

Only six months later, Morgan Stanley experienced its own rout. The world’s second-biggest mergers adviser announced in December that it had written down its subprime-related holdings by $9.4 billion after the firm’s traders misjudged how fast and far prices of the debt would fall. Their risk management had failed.

The Lebanese-born Taleb, a balding man who labels himself a philosopher of randomness, has an eerie knack for timing things right. His most recent book, “The Black Swan: The Impact of the Highly Improbable” (Random House), came out in May 2007, just months before the subprime fiasco rocked global markets and led banks to announce at least $208 billion worth of writedowns. The book’s message offered something of a preview of the crisis: that we’re all blind to rare events and routinely fool ourselves into believing we can predict risks and rewards.

Crisis, Crash, Collapse

Taleb argues that history is littered with high-impact rare events, known in quantspeak as “fat tails,” for their shape when plotted on a bell curve. He cites the Latin American debt crisis of 1982, the collapse of hedge fund firm Long-Term Capital Management LP in 1998 and the crash of the U.S. stock market in October 1987, to name a few.

As the founder and manager of New York-based Empirica LLC, a hedge fund firm he ran for six years until he closed it in 2004, Taleb built an investment strategy based on options trading. It was designed to bulletproof investors against blowups while profiting from rare events. His 20-year trading career has been marked by jackpots (like when he lucked out in trading options during the stock market crash of 1987) followed by long dry spells.

“If you lose money on a steady basis and then make money in a lumpy way, people think you’re crazy,” he says.

Hedge Fund Advising

While Taleb has stepped back from everyday trading, he remains an adviser to Santa Monica, California-based hedge fund firm Universa Investments LP. It opened its doors last year under the direction of Mark Spitznagel, 36, Taleb’s former trading partner at Empirica.

Universa has a so-called Black Swan Protection Protocol managed by Pallop Angsupun, a former Taleb student who’s hedging roughly $1 billion of client investments against certain events that can cause market declines. The firm has another $300 million pot betting on large positive jumps in individual stocks and is readying a similar, third fund several times that size, a person familiar with the funds says.

“Nassim and I share this genetic flaw,” says Spitznagel, a one-time Chicago pit trader who was a student of Taleb’s at New York University. “We’re not interested in the small frequent payouts. We want the infrequent huge payouts.”

Multimillion-Dollar Advance

Taleb has gone from being a leading Wall Street heretic — he rails against economists and quantitative model makers — to a mini institution whose appeal reaches well beyond the realm of finance. More than 370,000 copies of “The Black Swan” are in print in the U.S. and the U.K. It spent 17 weeks on the New York Times best-seller list and is being translated into 27 languages. It even outranks Alan Greenspan’s memoirs, “The Age of Turbulence: Adventures in a New World” (Penguin, 2007), among 2007 best-sellers on Amazon.com.

The success of “The Black Swan” has led to a $4 million advance for the English-language rights to a follow-up book, according to a person familiar with the deal. It’s tentatively titled “Tinkering” and will examine how to live in a world we don’t understand.

Taleb now charges more than $60,000 for some of his lectures, according to the London Speaker Bureau, a firm that places business, political and motivational speakers. He warns audiences against believing worst-case scenarios and making so- called naked, or unhedged, bets on the future that could lead to disastrous losses.

Australia Discovery

The message of “The Black Swan” — whose title describes a bird once thought not to exist, until it was found in Australia in the 17th century — has penetrated Wall Street trading rooms, says Aaron Brown, a risk manager at Greenwich, Connecticut-based AQR Capital Management LLC, which manages about $8.6 billion in hedge fund assets.

“You can’t say you haven’t read it or you read it but you’re not going to do anything in response in a trading or risk management role,” says Brown, a former Morgan Stanley risk manager who calls Taleb a friend while disagreeing with him that banks’ risk models are useless.

Now, everybody wants to talk about “black swans,” those highly improbable events that can cause havoc. The National Aeronautics and Space Administration’s Langley Research Center in Hampton, Virginia, has invited Taleb to talk about how to identify technology black swans as it prepares to send humans back to the moon and beyond.

Societe Generale

The U.S. Fire Administration, part of the Department of Homeland Security, wants him to address 200 executive fire officers to talk about the probability distribution of forest fires. He’s given talks about risk models for the U.S. Department of Defense, where he’s a member of the Highlands Forum, a Pentagon-sponsored study group on risk.

Taleb is no security expert nor does he claim any special knowledge of space technology. Instead, these groups want to hear him talk about how to apply his ideas on chance and decision making to their specific fields.

One day last December, Taleb stood before 30 top executives from Societe Generale SA, France’s second-biggest bank. The executives, including Chairman Daniel Bouton, had gathered at Prague’s five-star Hotel Aria, where each room is dedicated to a famous musician, for a conference organized by Paris-based business school ESCP-EAP.

The proliferation of bank mergers has resulted in fewer banks and a greater concentration of risks, Taleb warned, according to a person who attended. The probability of a devastating banking loss has increased rather than decreased, he said. The response was muted, and attendees walked out with copies of “The Black Swan,” the person said.

Marking a Shipwreck

About six weeks later, SocGen revealed the biggest trading loss in banking history, announcing that it had lost 4.9 billion euros ($7.2 billion) and blaming 31-year-old trader Jerome Kerviel.

Taleb’s fan club has grown far beyond the investment and research communities. When Tampa, Florida-based Odyssey Marine Exploration Inc. discovered a colonial-era shipwreck in the Atlantic Ocean last May with 17 tons of gold and silver coins valued at some $500 million, Greg Stemm, the company’s co- founder, happened to be reading Taleb’s book.

Stemm decided to name the site “The Black Swan.” Soon after, the two met for champagne in Los Angeles and bonded over the role of randomness in life.

Irked Statisticians

Taleb has made enemies, too. In August, The American Statistician, the quarterly journal of the American Statistical Association, came out with a special Black Swan issue that published a series of critical reviews alongside an article by Taleb.

“He characterizes statisticians as people who blindly assume things, and nothing could be further from the truth,” says Peter Westfall, the journal’s editor and a professor of information systems and quantitative sciences at Texas Tech University in Lubbock.

Even his one-time colleagues disagree with him. Robert Engle, a Nobel laureate in economics who teaches at New York University’s Stern School of Business in Manhattan, says Taleb’s book ignores a mass of literature on rare events called extreme value theory, which is often used to assess risks in insurance as well as finance.

“He’s reflecting an opinion that financial markets are sort of out of control,” Engle says. “I think a lot of mistakes are made, but I don’t think he helps us understand the mistakes.”

Jet Versus BMW

Taleb’s book blends highbrow philosophical musings with quasi-self-help advice that appeals to our fascination with success and chance occurrences. While Stephen Covey’s “The 7 Habits of Highly Effective People” (Simon & Schuster, 1990) purports to give everyone a road map on how to become the next Bill Gates, Taleb reminds us that skills and hard work aren’t always enough.

“Hard work plus luck is what gets you a jet instead of just a BMW,” he says over duck at a dim sum restaurant in London, where he’s conducting research with a colleague.

It’s much the same message he delivers in more formal settings. One day last June, Taleb gets up in front of about 40 people at Miller’s Academy, a West London lecture society, to talk about black swans. Surrounded by antiques and a fish tank stuffed with dead owls, he begins his trademark attack on Gaussian statistics, named after 19th-century German mathematician Carl Friedrich Gauss, who charted probabilities on a bell-shaped curve.

Skeptical Economist

In a bell curve, high-frequency events are represented at the top, or middle, and infrequent episodes are charted on the edge, or tail, of the curve. The tail is usually thin, reflecting rare, low-impact events. Gaussian statistics might work in casinos, but it can’t accurately help calculate stock market valuations, Taleb argues.

“With stocks, we don’t know if we’re overpaying,” he tells the audience.

“No self-respecting statistician in finance is using Gaussian statistics,” interjects Lord John Eatwell, an economist and president of Queens’ College at Cambridge University, who’s sitting in the back. “All models are Bayesian,” he says, referring to the theory derived from 18th- century British mathematician Thomas Bayes that allows for data to be constantly added to calculate probabilities.

Taleb shoots back: “Bayesian is necessary but not sufficient.”

Taleb, who sports a salt-and-pepper goatee and mustache and a 60-euro black Swatch watch, is often quick to take offense. At a conference in Italy, a group of students told him he looked like Umberto Eco, the somewhat paunchy Italian philosopher and author of the novel “The Name of the Rose.” Taleb says he promptly went on a diet.

Trader to Philosopher

For more than a decade, Taleb has been trying to transform himself from trader to philosopher.

“By the age of 30, I was emotionally outside the world of finance,” he says.

Surrounded by a collection of ancient sculpted Roman heads, Orthodox Christian icons and thousands of volumes spread throughout his suburban home north of Manhattan, Taleb has churned out a series of technical papers and books. His first mainstream book, “Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets” (W.W. Norton, 2001), which has 160,000 paperbacks in print in the U.S., was translated into 20 languages and turned him into a guru in some finance circles.

Taleb has learned about uncertainty firsthand. Born into a prominent Greek Orthodox Christian family, he says he witnessed Lebanon’s transformation from heaven to hell when civil war erupted in 1975. At the time, he was a 15-year-old student at Beirut’s Grand Lycee Franco-Libanais, an elite French-speaking school that was damaged during the war.

Wharton MBA

He listened to adults tell him that the conflict would soon end, only to watch it drag on for almost 17 years. His family’s home in Amioun, in northern Lebanon, was destroyed in 1982, when his grandfather, former Deputy Prime Minister Fouad Ghosn, was a member of parliament.

Taleb left Lebanon to attend the University of Paris and then got his Master of Business Administration in 1983 from the Wharton School at the University of Pennsylvania, where he says he fell in love with options. An options contract allows but doesn’t oblige an investor to buy or sell a security or index at an agreed price at some future date.

Two years later, he got his first lesson in financial uncertainty. After a brief stint as a trainee at Bankers Trust Corp., Taleb joined French bank Indosuez, now part of Credit Agricole SA, as a currency options trader.

Plaza Accord

On Sept. 22, 1985, France, Germany, Japan, the U.K. and the U.S. signed the Plaza Accord, an agreement to push down the value of the dollar to shore up the U.S. current account deficit. Taleb was sitting on currency options — which give investors the right to buy or sell a currency at a specified exchange rate — that had cost him pennies. The options exploded in value that day.

“I had no clue what had happened to me,” he recalls. “We were lucky. We made a lot of money but by accident.”

A French colleague, Jean-Manuel Rozan, later wrote about the episode in a memoir disguised as a novel called “Le Fric,” or “Cash” (Michel Lafon, 1999), in which he named Taleb and called him the Bobby Fischer of options, referring to the legendary chess player.

After this fluke, Taleb says he became obsessed with buying out-of-the-money options — puts and calls whose strike price is either lower or higher than the market price of the underlying security. An agreement to sell is a put option; an agreement to buy is a call option.

`Nassim the Dream’

A typical trade might work like this: Microsoft Corp. is trading at $35. Taleb would buy a put option, agreeing to sell another investor the stock at a strike price of, say, $25 in the next three months. He’s betting the stock will fall much more than it has done historically, making the option cheap to buy. If the stock fell further, to $20, he would exercise the option and force the investor to buy at $25, pocketing the difference. If the stock doesn’t fall, the option expires and Taleb has lost only the pennies he paid for it.

In 1986, Taleb moved to First Boston Inc. (now part of Credit Suisse Group), where fellow traders called him “Nassim the Dream,” recalls Demetrios Diakolios, a former colleague. At First Boston, Taleb, then 28, built what he terms a “massive” position in out-of-the-money calls on Eurodollar futures.

`He Cleaned Up’

On Oct. 19, 1987, he was sitting at a row of desks on First Boston’s trading floor at Park Avenue Plaza in Manhattan when his dream came true. The Dow Jones Industrial Average plummeted 22.6 percent in the biggest one-day drop in U.S. stock market history. The crash caused Eurodollar futures to surge after the U.S. Federal Reserve pumped liquidity into the banking system, lowering interbank borrowing rates. Taleb’s positions exploded once again.

“We all knew that he did well, that he cleaned up on that and made $35 million to $40 million,” Diakolios says of the sum the bank made on Taleb’s positions. “The equities guys below us thought, ‘Why did some guy upstairs make all this money on a day when everybody got killed?”’

The payday for Taleb was big. Without divulging the amount, he says 97 percent of the money he’s ever made was on Black Monday in 1987.

“There are concentrated pockets of luck,” he says.

After a few months of volatile trading, the market calmed down, and Taleb grew bored. In 1991, he moved to Union Bank of Switzerland, now UBS AG, as chief options trader. He lasted less than a year; he says endless meetings annoyed him.

Chicago Pit Trader

In 1992, Taleb turned his back on Wall Street. He moved to Chicago to become a pit trader and market maker at the Chicago Mercantile Exchange. In the pit, he saw how options are priced in real markets rather than from mathematical models. At the time, he was working on his Ph.D. in option pricing at the University of Paris Dauphine (which he completed in 199 and writing his first book, “Dynamic Hedging: Managing Vanilla and Exotic Options” (Wiley, 1997).

After two years, Taleb moved back to New York, where he worked at CIBC-Wood Gundy, a unit of Toronto-based Canadian Imperial Bank of Commerce, as global head of financial option arbitrage and then at Paris-based BNP Paribas SA, France’s biggest bank, as an options trader.

Teaching at NYU

In the mid-1990s, when he was still in his 30s, Taleb found out that the scratchy voice he’d attributed to too much shouting in the pit had a more ominous cause. He had throat cancer. The disease tends to strike smokers over 50. Taleb wasn’t a smoker except for the odd Friday when he would light up a pipe after a good trading week. After two years of radiation treatment, the cancer disappeared. Yet the effects linger, and Taleb says he remains paranoid that this particular black swan will resurface.

Taleb’s following grew in 1999 when he began teaching an evening graduate course at New York University. His class on model failure in quantitative finance attracted like-minded students, including Spitznagel.

After the course wrapped up in the evening, Taleb would go to the Odeon cafe in Manhattan’s TriBeCa neighborhood for drinks with students and Wall Street quants to talk about everything from pricing options to the failures of value-at-risk models, which banks use daily to decide how much to wager in the markets.

“It became an unofficial meeting place for people interested in quantitative finance and trading,” recalls AQR’s Brown, author of “The Poker Face of Wall Street” (Wiley, 2006).

Options in Bulk

Taleb quit BNP Paribas in 1999 and set up Empirica in Greenwich, Connecticut, bringing Spitznagel with him. Empirica wasn’t like most hedge funds. The Russian financial crisis and the collapse of Long-Term Capital Management after $4 billion in losses had spooked many investors. Taleb began offering hedge fund clients protection against a blowup like LTCM by offsetting some of their trades with options.

Empirica ended up acting like a superbroker or clearinghouse for buying out-of-the-money options. After spending millions on computer systems and giving their software programs code names like Igor, Taleb and Spitznagel would download 600,000 option prices every night and produce bids on 30-40 big blocks, getting them cheap by buying in bulk, Taleb says.

Guarantee to Investors

The goal was to protect investors against market crashes. Knowing how much they would pay for options, the two guaranteed investors they wouldn’t lose more than 13 percent a year.

“Our aim was not to make money,” Taleb says. “I make no claims of being able to beat markets.”

Empirica did outperform the market. In 2000, its returns rose by about 60 percent on the back of high volatility and the bursting of the dot-com bubble, Taleb says. The next year, after the Sept. 11 terrorist attacks, nervous investors came flocking. Then volatility dropped as the stock market slowly drifted down, removing the opportunities to profit from wide market swings.

In 2002, Empirica posted its worst year as returns fell about 12 percent, Taleb says, while the Dow Jones Industrial Average dropped 17 percent.

“I knew he was likely to lose money most of the time because it was kind of an insurance,” says Jean Karoubi, an Empirica investor and chief executive officer of LongChamp Group Inc., the New York-based hedge fund unit of Silvercrest Asset Management Group LLC, which manages about $10 billion.

Fearing New Cancer

Taleb and Spitznagel moved Empirica to midtown Manhattan in 2003 and changed tack for some clients. To profit from low volatility, they began selling at-the-money options — those close to the market price of the underlying security. In 2003 and 2004, Empirica posted small positive returns, Taleb says. Eager to focus on writing “The Black Swan” and still afraid, he says, that his cancer might return, Taleb shuttered Empirica in 2004 and returned about $380 million to investors.

“I was fed up,” he says. “I just wanted to write, and I had writer’s block.”

“The Black Swan” was itself a black swan — an unexpected hit. The book swings from advice on how to distinguish between positive and negative black swans in everyday life to ruminations on Taleb’s hero, Karl Popper, the Austrian-born 20th-century philosopher who argued that scientific theories should be tested not through attempts to verify them but through efforts to prove them false.

`Go to Parties!’

“If you are in banking and lending, surprise outcomes are likely to be negative for you,” Taleb writes. “Put yourself in situations where favorable consequences are much larger than unfavorable ones.”

He adds little tips such as: “Go to parties! If you’re a scientist, you will chance upon a remark that might spark new research.”

Taleb has a foot in academia. He’s now a visiting professor at the London Business School, where he’s conducting experiments with Dan Goldstein, an assistant professor of marketing, on the psychology of risk and decision making. Taleb wants hard proof that people misjudge risks.

In one pilot experiment, they posed the following question to participants: “You’re on vacation in a foreign country and are considering flying the national airline to see a special island you have always wondered about. Safety statistics in this country show that if you flew this airline once a year, there would be one crash every 1,000 years on average. If you don’t take the trip, it is extremely unlikely you’ll revisit this part of the world again. Would you take the flight?”

Everyone answered yes, assuming that one crash every 1,000 years was a minimal risk.

Finding the Extremes

Another group was given the same problem except they were told that an average of 1 in 1,000 flights on this airline crashes. Although it’s the same risk mathematically, 30 percent refused to fly when presented with this wording.

“This one-in-every-X-years framing is something you hear concerning market crashes in financial reports on TV,” says Goldstein, 38, who holds a Ph.D. in psychology.

Extremes are more likely in finance than in the real world, Taleb says. At a conference for risk managers in London last June, he used the following illustration: “Say I sample from the world population and find two people cumulatively 14 feet tall. What’s the most likely allocation for Gaussian? One and 13? No, it’s seven and seven.”

In wealth, it’s the opposite. “If we sample from the world population and get two people whose net worth totals 14 million pounds, what’s the most likely combination?” he asked. “Seven and seven? No, it’s 5,000 pounds and 14 million pounds minus 5,000 pounds.”

`We Need Chutzpah’

He gives these two domains different names. The first he calls Mediocristan, where, if you have a large sample, the average of an independent, identical, random set of variables will converge in the middle. In Taleb’s other domain, Extremistan, average outcomes have little meaning. If financial markets are governed by extreme movements and unexpected events, we shouldn’t be fooled into believing worst-case scenarios, he says.

“We need more chutzpah,” he says. “If someone tried to do stress testing before the stock market crash in ‘87, they would not have tested for 20 percent down.”

Taleb likens modern-day financial markets to medicine in the 1800s, when going to a hospital in London or Paris multiplied your risk of death by four times, he says. Similarly, quants increase risk by deploying flawed financial tools designed to reduce it, he argues.

For Taleb, the ills besetting financial markets are a vindication of his ideas. Like medicine, though, he isn’t offering easy cures.