JUNE 2008 ISSUE

RE: "FLIGHT OF THE BLACK SWAN"
May 2008
About your story on Nassim Taleb: I followed this debate closely about 10 years ago, while the Russia crisis was unfolding. Banks typically rely on value at risk (VAR), which proved hazardous. VAR modeling is based on historical worst- case scenarios, but a new and different crisis raises the possibility that a new worst-case scenario could arrive. This is intriguing for researchers, but dangerous for risk managers. Regulators have been too concerned about capital as opposed to liquidity. Supervision may improve if it is based on risk as well as rules.
RICHARD SEGAL, Renaissance Capital, London

Even though I am no fan of Taleb's, I found your article to be quite an enlightening run through both his personal history and some of the arguments in the field. Please keep them coming.
HAMAD ALHOMAIZI, Kuwait

I graduated from the Stanford Graduate School of Business in 1972 and was an investment banker for more than 20 years before retiring. Back in my day, we did linear programs by hand. You'd name a variable so horrible that if it ever showed up in the optimal solution with any positive coefficient you'd know the answer was wrong and you'd go through additional iterations to eliminate it. We called it "Big M." Taleb calls it "The Black Swan." If that once-in-a-million chance occurred, you'd be out of business. Of course, you might in the real world take a one-in-a-million chance, but you'd do it knowingly once you understood the Black Swan concept. I think all such conceptual thinking disappeared once computers became widespread and answers were calculated with complete precision. People think precision gives them control, whereas it really places the unknown in control. Only widespread application of Nassim Taleb's concepts, coupled with strong central bank intervention, will get us out of this one-in-a-thousand-year flood with our heads above water.
CHRIS WYSER-PRATTE, New York

RE: "SCHOOLSFLUNK FINANCE"
March 2008
This is unbelievable! There has to be legal recourse for these cities. It seems like such a blatant crime committed by banks and their lawyers. I certainly hope this article gets the widest possible dissemination.
MIKE BARTON, San Antonio

Updates

Alabama'sCredit Crash

For Jefferson County, Alabama, and its 659,000 residents, the credit crisis that's sweeping the globe is plowing full force into their living rooms. Three years after Bloomberg Markets published "The Banks That Fleeced Alabama" (September 2005), the county, home to Birmingham, is struggling with rising interest rates on its bonds and demands for penalty payments from banks as it tries to stave off the largest-ever bankruptcy of a U.S. county.

Jefferson County sowed the seeds of its turmoil in 2002 and '03. Back then, JPMorgan Chase & Co. led a group of banks that sold the county $5.8 billion of interest rate swaps to hedge against the lending rate risk on sewer bonds. Since then, rates have gone against the county. In November, it faced a $259 million liability in the deals.

Now the county, which takes in $11.5 million a month from sewer use, can't afford to meet sewer bond payments that may be more than $21 million a month. In April, following talks with Wall Street banks, Jefferson County advisers met with Federal Reserve officials while state lawmakers considered steps to avoid the biggest municipal bankruptcy in U.S. history.

"An 18-wheeler is about to hit the courthouse," says Bettye Fine Collins, the elected commissioner who handles financial affairs for the county.

The county is short of cash because interest rates on $3.2 billion of sewer bonds jumped as high as 10 percent in February from 3 percent in January. The sudden surge followed credit rating downgrades of both the county and its bond insurers. After the subprime mortgage meltdown saddled banks with at least $245 billion in losses, Jefferson County's bond insurance companies were downgraded because they had insured subprime-filled collateralized debt obligations. Moody's Investors Service cut New York-based FGIC Corp.'s ratings six levels to A3 in February. It also cut XL Capital Assurance Inc., a unit of Bermuda-based Security Capital Assurance Ltd., to A- from Aaa. The county itself had its credit rating lowered to junk by Standard & Poor's in March.

Christopher "Kit" Taylor, former head of the Municipal Securities Rulemaking Board, says Jefferson County used swaps the same way some homebuyers used subprime or interest-only mortgages. "Jefferson County was looking for an easy way out," he says. "Nobody wanted the party to end, but it did."

Bloomberg Markets' 2005 feature reported that the interest rate swap agreements tied to the bonds reaped $100 million in fees for banks. The article also said the county overpaid by $60 million. Now it turns out the swaps didn't protect against rising interest rates, as the county had hoped. Instead, interest rates have declined. The county is liable for $180 million in collateral. It doesn't have the money.

"They were dealing with some very complex securities, and I don't believe the consequences and ramifications were disclosed to them," says U.S. Representative Spencer Bachus, an Alabama Republican who sits on the House Financial Services Committee and who represents portions of Jefferson County. "They're very risky packages."

The hazard intensified in late 2007, as investors demanded more for municipal bonds across the U.S. Investment banks historically have auctioned municipal bonds as frequently as every week. When buyers grew scarce in February, banks, which had for years used their own money to keep the auctions from failing, didn't do so. The auctions stalled, forcing Jefferson County to pay penalty interest rates.

County commissioners say they can't raise sewer fees, which have already increased more than fourfold during the past decade. Officials also ruled out new taxes.

"I certainly don't want bankruptcy," says Jefferson County Commissioner Jim Carns. "It's obvious that if everything fails, that is a possibility." Alabama State Senator Steve French says he worries the crisis could saddle every Alabama borrower with higher costs. In April, he introduced state legislation in a bid to prevent the county's bankruptcy.

Mike Dunnavant, the owner of a wine bar in Birmingham, says the people of Jefferson County will wind up footing the bill for the misbegotten deals, no matter what happens. He says the banks that fleeced the county will do fine. "They'll get their money," Dunnavant, 57, says of the banks. "We'll be paying for it."
WILLIAM SELWAY

Paulson's Insurance Twist

The federal government should regulate insurance companies because states have too many rules, U.S. Treasury Secretary Henry Paulson suggested in remarks at the Treasury on March 31. "A state-based regulatory system is quite burdensome," Paulson said. "It allows price controls to create market distortions."

Paulson's plan would let the insurance industry choose between state or national oversight. Right now, insurers and their $6.1 trillion of assets aren't regulated by the U.S. Securities and ExchangeCommission or any federal body. Under the proposal, insurance companies that chose federal regulation would be able to raise rates without getting permission.

Paulson's plan would be a blow to protection for policyholders, says Travis Plunkett, legislative director of the Consumer Federation of America. "We don't buy the notion that consumers will benefit if insurance companies get to choose who regulates them," Plunkett says. "We think the proposal is structurally flawed."

In "Toothless Watchdogs" (February 2008), Bloomberg Markets reported on another aspect of state insurance regulation. The story showed that state regulators may do more to serve the insurance industry than to help consumers because a patchwork of rules lets each state act as it pleases. Plunkett says consumers need stricter regulation of insurance companies. Paulson says the industry is overregulated.

Some states have corrupt officials or conflicts of interests that dissuade regulators from stopping or punishing insurance companies that cheat customers, the story reported. Such conflicts allow property insurers to routinely underpay on claims, as Bloomberg Markets reported in "The Insurance Hoax" (September 2007).

Two companies that homeowners have sued for underpaying customers, State Farm Mutual Automobile Insurance Corp. and Allstate Corp., the two largest U.S. auto and home insurers, say they support Paulson's proposal. State Farm and Allstate deny they have underpaid customers.

Paulson's 218-page report says the optional federal regulation would be designed like the dual-chartering system for U.S. banks. Paulson's plan also suggests that Congress establish a federal Office of Insurance Oversight within the Treasury to regulate non-U.S. insurers.
DARRELL PRESTON

Sabanc Women Reign

The torch is passing to a third generation of Turkey's Sabanc family, with women coming to the fore. Suzan Sabanc Dinçer became the first woman to head a major Turkish bank when she was elected chairwoman of Akbank TAS,, the country's biggest financial institution by market value, on March 28. Güler Sabanc, Suzan's cousin, took over as chairwoman of Akbank's parent company, Hac Ömer Sabanc Holding AS,, in 2004.

Sabanc Dinçer, 43, will succeed her father, Erol Sabanc, who will become honorary chairman. He'll remain on Akbank's board, where he has served as a director and then as chairman for the past decade. Bloomberg Markets profiled Sabanc Dinçer in "Daughter of a Dynasty" (April 2008).

The handover marks a generational shift in the family business, built by Hac Ömer Sabanc and his six sons. Sabanc enterprises now account for more than 2 percent of Turkey's gross domestic product. Erol Sabanc was the last of Hac Ömer's children to run one of the family's companies, which include joint ventures with Carrefour SA and Toyota Motor Corp.
BEN HOLLAND

Ospraie Goes Fishing

Dwight Anderson's Ospraie Management LLC, already the world's largest commodities hedge fund firm, will be getting a lot bigger after he agreed to pay $2.1 billion for ConAgra Foods Inc.'s commodity trading and merchandising operations in March.

ConAgra Trade Group, which Ospraie will rename Gavilon LLC, runs grain elevators, rail cars and barges that transport wheat, soybean oil and other commodities, mostly in North America. The company also trades oil and natural gas. Bloomberg Markets reported on swings in the performance of Ospraie and other commodities hedge funds in "Dwight Anderson's Wild Ride" (December 2007).
SAIJEL KISHAN

Renaissance Takes a Skid

Hedge fund titan Jim Simons is experiencing one of the biggest losses of his career amid the $1.9 trillion industry's worst start in almost two decades. Simons's $18 billion Renaissance Institutional Equities Fund had declined 12 percent since peaking in May 2007, investors with direct knowledge of the situation said in April.

Hedge funds lost an average 2.77 percent of their value in the first quarter, according to monthly data compiled by Chicago-based Hedge Fund Research Inc. Simons has produced average annual returns of almost 40 percent since 1989 for investors in his Medallion Fund, which now manages money only for Simons and Renaissance employees. Bloomberg Markets profiled Simons and his quantitative strategy in "The Code Breaker" (January 2008).
KATHERINE BURTON

May/02/2008 18:30 GMT

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