[00:02:57] Scott Patterson: The Chaos Kings are a term that I came up with in this book to describe a group of traders or investors who have managed to, in various situations, benefit and actually prosper during times of chaos. They see something coming that looks risky and dangerous, and they make trades that can benefit from it.

[00:03:19] Scott Patterson: The people I mainly profile, Mark Spitznagel and Nassim Taleb of Black Swan fame, are constantly trading around the risk of chaos in the markets. So there are different varieties. Some use very advanced physics techniques to try to predict when something crazy is going to happen.

[00:03:38] Scott Patterson: Others rely on their gut instinct, like Bill Ackman, who I profile in the opening section of the book. In January 2020, Ackman saw what was going on with Covid-19 and was really freaked out by it. He understood the nature of the risk that the pandemic posed before many others did.

[00:03:58] Scott Patterson: So he was able to enter these trades very cheaply because other people weren’t recognizing the risk, and ended up making billions of dollars when things went south. Ackman highlights one of the key traits of this Chaos King trading strategy, which is you have to panic early. Panicking isn’t something you usually want to associate with investing or trading, but in these situations, it sometimes is good to panic because if you don’t, if you wait, if you try to assess.

[00:04:31] Scott Patterson: At the risk of the situation, it’s going to get ahead of you, and you’re going to be too late, and you’re going to get run over. Similarly, in the mid-2000s, there were hedge funds that saw what was going on in the housing market and the derivatives markets. They were able to trade earlier than others, very cheaply, and get into these positions that ended up making billions of dollars.

[00:05:00] Scott Patterson: So these are very profitable trading strategies because of the nature of the risk that occurs and the cheapness with which you can enter these trades, creating explosive returns. That’s how Mark Spitznagel explains his strategy, which is explosive upside return. You can buy something like a derivative and option contract for, let’s say, 40 cents, and when the volatility really hits the fan, you can sell it for $60. And that’s something they have done. So that shows you how it’s a crazy, sort of out-of-this-world game that can be made on these trades.

[00:05:38] Clay Finck: It’s interesting that you mentioned Ackman there. He made $2.6 billion, I believe, on the drawdown in Covid. But the intriguing thing about Spitznagel is that he has profited from these downturns over and over again.

[00:05:52] Clay Finck: He has figured something out that a lot of other people haven’t, and it’s remarkable how most investors tend to ignore the possibility of calamity or simply expect to weather through it by holding onto their investments. Meanwhile, Spitznagel is actively seeking to thrive when that calamity and chaos strike.

[00:06:12] Clay Finck: To provide more background on Mark Spitznagel, he initially launched a hedge fund with Nassim Taleb in 1999. However, they eventually shut it down in 2004. Then, in a very timely manner, Spitznagel relaunched the fund in 2007, aiming to once again profit from these swift drawdowns. So, could you expand a little bit more on how Spitznagel thrived in these times of calamity?

[00:06:38] Scott Patterson: Yeah, so as you said, the strategy… Got it. It started in 1999 with the launch of Empirica, and Mark and Nassim met each other at New York University. They had both been dabbling in these strategies where you buy derivative contracts very cheaply, and when chaos hits, you benefit greatly.

[00:06:58] Scott Patterson: Mark had previously done that, and Nassim had done the same through some major events in the 1990s, like the Asian flu, where they both profited. So when they met, it was a great meeting of two minds that had discovered similar attributes in the market: investments that could be acquired at a low cost but with explosive returns.

[00:07:22] Scott Patterson: They launched Empirica, which was the first-ever so-called tail risk hedge fund. It wasn’t designed to invest in the stock market or commodities. They focused solely on entering positions with explosive upside potential during major downturns.

[00:07:36] Scott Patterson: The challenge with this strategy is that during normal times, it tends to lose a little bit of money every day or every month. They could go through these fallow periods where they weren’t making significant gains. Emotionally, it could be tough to endure. However, they performed very well in 2000 and 2001 during the dot-com blow-up.

[00:07:59] Scott Patterson: But then things settled down when Greenspan lowered interest rates and volatility decreased. Nassim became frustrated with the day-to-day bleeding, as they referred to it. It was emotionally challenging to experience that. As a result, he made the decision to shut down the hedge fund, believing it was detrimental to his health. Mark, on the other hand, thought Nassim was crazy because he truly believed in the strategy. He believed they had something truly unique, which they did.

[00:08:30] Scott Patterson: Nassim took a few years off and pursued other endeavors, including working at Morgan Stanley. However, he was always contemplating how to refine the strategy, how to make it better and more efficient.

[00:08:43] Scott Patterson: So in 2007, as you mentioned, he relaunched with good timing. He had a sense that it might be the right time to do so. Coincidentally, it was the same year that Nassim published “The Black Swan.” Both of them had excellent timing. “The Black Swan,” as everyone knows, is about extreme events, not only in the markets but in the world, and how people tend to underestimate these extreme events. People prefer not to think about them, and various behavioral biases come into play. There’s a recency bias where people believe that what happened yesterday will happen tomorrow. However, that’s not how the world works, but it’s how people think. If it didn’t rain yesterday, they won’t need an umbrella today. That’s how people are.

[00:09:34] Scott Patterson: They launched in 2007, and Nassim wasn’t directly involved in the day-to-day trading of the firm. He provided advice to the team occasionally, but mainly, especially with the fame he gained from “The Black Swan,” he helped bring visibility to Universa. However, it didn’t gain much traction. They had a few initial investors when they launched, but Mark had to travel around the country in 2007 to early 2008 to pitch their strategy, and nobody wanted it. Despite the signs of high volatility in the markets, no one wanted to invest in Universa.

[00:10:11] Scott Patterson: The reason for this was that the returns of a hedge fund like Universa are very uneven, and that’s not desirable for most investors. Modern portfolio theory favors trading strategies with steady returns and low volatility, where you have a good idea of what to expect. Universa, on the other hand, incurred losses year after year and then made billions of dollars. For most investors, such as pension funds, it was a difficult sell. It was considered a loss on their books. Justifying such a unique and unusual strategy, where they were losing millions of dollars a year, was challenging.

[00:10:51] Scott Patterson: Then, around mid-2008, things started getting chaotic. The collapse of Lehman Brothers, Fannie Mae, Freddie Mac, and AIG in September 2008 changed the situation dramatically. Suddenly, Universa started making massive gains, with their portfolio skyrocketing by 100%. 

[00:11:06] Scott Patterson: So, that got them a lot of attention. I was the reporter who first broke the news about their returns. I actually broke the news of Universa’s launch in 2007 and also reported on Nassim shutting down his hedge fund in 2004. So I have known them for a long time and have been following their performance closely. They have remained controversial, but they can proudly say that they created an entirely new investing strategy, and not many people can claim that accomplishment.

[00:11:39] Clay Finck: It’s funny when Spitznagel relaunched the fund. In your book, you described it as the “Goldilocks” period, where markets were calm and everything seemed well under control, leading investors to become complacent. When I hear about investors who perform exceptionally well, I believe it’s all about identifying market mispricings. They are able to purchase options that are initially inexpensive but eventually become highly valuable. They may not know the exact timing of when this will occur, whether it’s this year, next year, or the year after, but eventually, it happens, resulting in strong outperformance.

[00:12:16] Clay Finck: The intriguing aspect is that despite their strategy being somewhat well-known, many copycats were unable to achieve similar results. So what do you think set their strategy apart from the copycats?

[00:12:29] Scott Patterson: I wish I knew, you know, then I’d launch my own tail-hedged hedge fund. I’ve talked to Mark about this a lot, what is it that they do? And he says it’s trial and error. We’ve been doing this for decades, we really know the market, we know what we’re doing. Since they’ve been around so long, they’re known on the street as a firm that will do these trades that hardly anybody else normally wants.

[00:12:59] Scott Patterson: Their trades are bets on a one-month decline in the S&P 500 of 20%, which is kind of crazy, you know, because that doesn’t happen very often, obviously. But they enter those trades time and again, and the counterparties, the firm selling those trades, just see that as steady revenue, you know? Yeah, these nuts over here, they’re going to bet on this thing that we know is not going to happen. That’s millions in our pockets. So they have developed these relationships with the counterparties and the brokers on Wall Street that, they’re sort of like a market maker for these kinds of options that few others want to buy. So I think that’s part of it. They have a sort of first-mover advantage.

[00:13:49] Scott Patterson: I think also there are other strategies that they employ that lower their cost because basically, at the end of the day, this strategy lives and dies on the cost of entering these trades. The clients give them the money, they go out, they build the portfolios of these far out-of-the-money put options. The cheaper you can do that, the longer you can last, the cheaper it is for your clients. So one thing they do is they actually sell options that are nearer to the current price of the stock that they think are more accurately priced or they might actually be able to make a profit on those trades.

[00:14:34] Scott Patterson: So that helps bring down the cost, the structure of the strategy. That’s something I would obviously have no idea how to do. I wouldn’t recommend your listeners try to do that either. And it’s also why this isn’t a strategy for everyday investors. If everyday investors try to replicate this, they would probably lose money over the long run because you have to keep rolling over the trade.

[00:15:01] Scott Patterson: More likely than not, people who think they’re going to do this will end up spending money for six months or a year and think, “This is stupid. I’m losing all this money. I’m not making anything.” And that’s when you have to overcome that instinct and keep doing it, waiting for it to happen, which could take years. Eventually, you make a ton of money when everyone else is losing. This has multiple benefits because you suddenly have an infusion of cash when everyone around you is losing cash and the market is down. You can buy when there’s blood on the streets, quite literally.

[00:15:44] Scott Patterson: It’s a sort of Buffett-like strategy in some ways. He waits until things are really bad for everybody else, then he has all this dry powder and goes in to get great deals. Spitznagel actually sees himself as a sort of value investor. He believes these options are dirt cheap, underpriced according to the risk. He buys them, and normally they expire worthless. They’re junk, but sometimes they turn out to be a gold mine.

[00:16:14] Clay Finck: One of my favorite parts of the book was the involvement of Nassim Taleb despite Spitznagel being the brains behind the strategy. I wasn’t too familiar with Taleb’s background prior to him writing these bestselling books.

[00:16:28] Clay Finck: Could you talk about what he was up to prior to getting involved with Spitznagel, and then how they met and eventually launched this strategy?

[00:16:38] Scott Patterson: Yeah, Taleb was born in Lebanon, and he was growing up in Beirut when the war broke out there in the eighties. So, you know, he had sort of an up-close look at how a normal world can suddenly deteriorate into total chaos and war.

[00:16:56] Scott Patterson: He moved away in his teens and, you know, studied business in France for a while. Then he came to America and went to American universities. He worked in a business school. That was one place he attended, and it was there that he learned about options, he told me. And he really grew—I mean, it’s kind of weird to think about it, but he really grew fascinated by these things that I think to most people would just seem really boring.

[00:17:29] Scott Patterson: But he, he looked at it and he thought, there are strange properties to these options that a lot of people don’t really understand. So then he started trading on Wall Street, working for various firms, trading options. He was really good at it. At one place, he became known as the Bobby Fischer of options, an homage to the famous chess player.

[00:17:54] Scott Patterson: And then in 1987, he found himself at First Boston on the trading floor in Midtown Manhattan. He had been, you know, dabbling in options and other derivative contracts. And one thing he started doing was buying these really cheap positions on options on Euro dollars. I’m sure your listeners don’t want to know what those are, but like futures contracts on Euro dollars, and he had built up this big position, you know, on these Euro dollar contracts, very cheap contracts.

[00:18:27] Scott Patterson: So Black Monday comes along in October 1987. Everybody gets wiped out. He’s there on the floor. This is a scene I, you know, described in the book. People are just crying and freaking out. His boss is sitting there at his desk, begging the numbers to stop moving. And, you know, everybody’s shell-shocked.

[00:18:48] Scott Patterson: Nassim’s positions are doing pretty good. He’s looking around and saying, “Well, you know, I’m…” He didn’t really know why at the time it was so chaotic. People didn’t even know why the market had crashed so much. So that was Black Monday, but his positions didn’t really take off until the following day.

[00:19:10] Scott Patterson: When the Federal Reserve infused billions of dollars into the financial system, it had this weird effect on the contracts that Nassim owned. They went parabolic, which means up like a rocket. So, you know, he told me about how he was looking at his positions and saying, “You know, stuff he bought for 50 cents, calling the floor broker saying sell for 300,” and the broker would call him back and say, “Sell for 350. Sell for 400. Sell for 450,” and it went on like that.

[00:19:45] Scott Patterson: This was a move that is just not calculable in these contracts. It shouldn’t have existed in the history of the universe. You know, they’re so far out of the realm of statistical probability that you can’t even really calculate it. So that’s when he really got this lesson on how the normal parameters and probabilities that Wall Street uses to measure the risk and potential profit of various strategies were just totally off at the time.

[00:20:16] Scott Patterson: He wasn’t really sure what was going on, but it definitely intrigued him. So he continued to research it, pursue these trades. He ended up in the ’90s writing a sort of technical book about trading derivatives that explained his pursuit of understanding why this stuff happened.

[00:20:35] Scott Patterson: And then, you know, in 1999, he launched Empirica with Spitznagel, but he always comes back to Black Monday for him. He constantly brings that up and says it was the greatest trading day of his life, and it, you know, made him rich. So yeah, it was the seminal event.

[00:20:55] Clay Finck: Now Taleb, when you’re talking about him in your book, he stated that or he believes that financial markets and the economies that depend on them have become increasingly complex, unstable, and prone to crashes.

[00:21:09] Clay Finck: You know, he very much believes that we live in a world with increasing fragility and increasing uncertainty as time progresses, and many investors are underestimating the level of risk and fragility in the overall system. What are some of the things you think are going through his mind for why he so strongly believes this, and what are your thoughts on why we need to maybe be aware of just how fragile and uncertain our world is today?

[00:21:41] Scott Patterson: Yeah, there are a couple of reasons why he thinks that it’s all really interesting. Some of it comes back to complexity theory, which he really started reading a lot about in the 2000s, and he got to know some very prominent complexity theorists. It’s hard to say what complexity theory is, you know, it’s got multiple definitions, but it’s basically the study of the interconnections of various properties and phenomena in economies and risk systems in financial markets.

[00:22:12] Scott Patterson: And part of the idea is that as systems become more complex and more interconnected, they can become more fragile. As one part of the system breaks down, it sort of ripples through the system and affects the rest. So the whole, you know, you pluck one piece of the spider web and the whole thing comes down.

[00:22:36] Scott Patterson: So that’s kind of the core of it: the global economy and the financial system are more interconnected than ever. And I think that 2008 was a perfect example of that. You thought one part of the world economy, the US housing market, declined, which was not expected, but if it had just been a decline in the price of houses in the United States, we would not have seen a global financial crisis. The financial system was all connected through these derivatives. I don’t know if people remember, you know, endless stories about credit default swaps and collateralized debt obligations and how they were all bundled together, and all the banks had bought them and they had sold them to pension funds.

[00:23:25] Scott Patterson: So through complex interrelationships in the financial system, a sort of blip in one part of the economy triggers these explosions all throughout it, threatening to take down the entire economy. When you think about Covid-19, that was something that definitely was global, but you know, we haven’t seen anything like that in such a long time.

[00:23:48] Scott Patterson: And something that Taleb and others have been warning about is that the risk of a pandemic spreading in ways that they’d never done before is higher than ever because of global interconnectivity, mainly through increased plane travel. So you saw this outbreak in Wuhan, China. Maybe in previous outbreaks, it could have been contained.

[00:24:10] Scott Patterson: But China’s a very interconnected society. People travel a lot. Before the lockdown in Wuhan had been implemented, 5 million people had left the region. So it spread very quickly despite efforts to contain it. It was uncontained and it spread throughout the globe. That pandemic caused the global economy to seize.

[00:24:30] Scott Patterson: Essentially, it just seized up and stopped. And you know, we’re still feeling the ramifications of that through inflation and issues with the supply chain that are getting worked through. But those are two examples of how increased complexity and interconnections in society are leading to more fragility and financial risk.

[00:24:51] Clay Finck: Your book talks quite a bit about black swans and black swans. It’s almost this phrase that just gets thrown around all the time. There’s a black swan every other year now, it feels like, and as I mentioned, it almost seems to be like a feature of today’s increasingly fragile economy. So I’d love to get your thoughts in general on how people can avoid being blindsided by black swans. Is it true that black swans really can occur every year?

[00:25:24] Clay Finck: Or I believe there’s another term, I don’t know if it’s “gray swan,” where there are these kind of tail risk events, but they’re not a fat tail far out on the bell curve. What are your general thoughts on this?

[00:25:40] Scott Patterson: Yeah, it’s definitely sort of a frustration to define what a black swan is. I know that Nassim feels the frustration because, you know, I remember a debate that he was having with somebody who was challenging his conception of black swans, and he said, “Look, it depends on where you stand. Was 9/11 a black swan for the terrorists? No, because they could see it coming. Was it a black swan for the pilot? Yes.” So there are some complexities around it. And people endlessly debate, like, was the global financial crisis a black swan? Taleb would say no, it was a gray swan, as you said. Something that he had predicted, he had, you know, he was on record as predicting the failure of some of the big mortgage lenders like Fannie Mae. I don’t know if he had predicted quite the collapse that we saw because you would have had to really know how thoroughly these derivatives have been spread through the financial system. Now, there were some people who did see that, who, you know, people like profiled in Michael Lewis’s book, “The Big Short,” who actually were aware. So it kind of depends on who you are, if something is predictable or not. For most people, I think it was a black swan.

[00:27:07] Scott Patterson: So in terms of how to protect yourself, it’s pretty tricky, you know, and it’s something that I endlessly went over with my editor on this book: how to tell people how they can protect themselves from black swans. It’s not easy. Especially for everyday investors. What I would say is, you have to be humble. You have to be aware of the potential for big drawdowns and try not to take positions that are vulnerable to those kinds of events. So I would say, don’t invest in a bunch of risky startups, play it safe. And you can’t have a universal strategy. Like I was saying earlier, it’s just so hard to replicate that. But the historical record shows that the safest investment you can make over the long run is a very simple strategy. You invest in the S&P 500 and you hold onto it over the long run. You will get hits, but you’re not going to blow up.

[00:28:12] Scott Patterson: And that’s where hedge funds and other derivatives traders make mistakes and blow up. They literally lose all of their money in these events. We saw some catastrophic blowups in 2020. Very quickly, these firms can lose all their money in a day because they were not positioning themselves to be able to weather the extreme events. They were making very risky bets that were based, you know, predicated on things happening day-to-day as they normally do. And then something crazy happens, they’re like, “Oh, well, you know, we couldn’t see that coming. Who could see a pandemic?”

[00:28:51] Scott Patterson: But the point of Taleb and Swiss Nagle is that you kind of always have to be worried about that. You never know when it’s going to come. A black swan is totally unpredictable in Taleb’s definition of it and can happen very rapidly. You just have no idea this is going to happen. So I think the idea is just to try to avoid taking too much risk. Certainly, do not use leverage or borrowed money. There are a lot of people out there that are day traders. They’ve become day traders with the pandemic. People were staying home, had nothing to do, and all of these sports bettors started dabbling in day trading.

[00:29:37] Scott Patterson: I may sound like a grumpy gus or something, but to me, I think it’s just a huge mistake to try to day trade. The record shows that nobody is any good at that, you know? Yeah, I can count on a single hand the number of investors who have been able to beat the S&P 500 over the years. Warren Buffett, in 2007, made a bet against hedge funds. Over the next 10 years, he bet that the S&P 500 would outperform this basket of hedge funds over the next decade. And I kind of thought at the time, like, “Wow, hedge funds had actually been doing really well.” You know, they had actually beaten the market in recent years. It was a pretty steady time post-dot-com bubble. But Buffett was right. In that 10 years, the only year that hedge funds did better than the S&P 500 was 2008. And the S&P ended up gaining something like, I forget the exact numbers, but 140% compared to 36% or 37% for hedge funds. And these are hedge funds, you know, they’re getting paid millions of dollars, they’re getting rich off fees, and they can’t beat what your Aunt Molly is going to do if she puts her money in a Vanguard S&P 500 index.

[00:31:03] Scott Patterson: And that’s just been the way it’s been, you know? So Spitznagel, in the past few years, he’s been analyzing various strategies that are popular with hedge funds. Like putting some money in the S&P 500, some money in gold, some money in Swiss Francs bonds. He looked at all sorts of permutations of these strategies. None of them, over the period that he was looking at (I think since like 2008), has beaten a simple investment in the S&P 500, except for Universa, which has actually beaten it.

[00:31:39] Clay Finck: What were Universal’s average annual returns? 

[00:31:42] Scott Patterson: They had audited annual returns through 2019 of over a hundred percent, which is kind of insane because in some of those years they lost money. But when you have a gain of 4000%, which was after, actually after that audit, that kind of makes up for a lot of the down years.

[00:32:04] Clay Finck: I pulled this quote from your book: “Black Swans are, by nature, undefinable, uncontained, incomprehensible, unpredictable, uncertain, chaotic, random, wild, out-of-control crises.” It reminds me of what you’re talking about there, how a lot of hedge funds, they’ll do things like lever up or push into riskier assets to try and juice the returns. And it looks really good, maybe for a few years. It looks like things are all fine and well, and then all of a sudden, that event hits that’s just totally unexpected, and they just get blown up. And I think that’s a big reason why Taleb and Spitznagel, they see the possibility of these things happening, and they’re just like, “Yeah, the number one thing is capital preservation for them.”

[00:32:54] Scott Patterson: Yeah, absolutely. Risk management is entirely different from, you know, people trying to look at the strategy and say, “Well, this is not making money all these years, and that’s no good for investors.” They are not speculators; they’re not making bets on the direction of the market. They have a risk management strategy that is aimed to preserve the capital of their investors to the maximum extent possible. I think that is one area that confuses people about their strategy because, yes, they have actually done a lot better. If you just put money in a Universa fund, you would have done pretty well. But that’s not what they tell people to do. Their own investors, their strategy is that clients put in about 3% of their capital into the Universa fund, and then the rest optimally in the S&P 500. They can do whatever they want with that other 97%, obviously. But what they do is they just use that as a sort of proxy for the investment and this Universa strategy would do.

[00:34:04] Scott Patterson: And that is in contrast to other risk management strategies, like the most popular strategy called 60-40, which is 60% in stocks and 40% in bonds, which has performed terribly in the past few years. I think 2022 was the worst period on record, or in many recent years for that strategy. It had worked okay in other years though because the bond portfolio goes up when stocks go down, typically. So you’ve got a hedge there. But what Spitznagel will say is you’re giving up a lot of upside potential in stocks when you do that. When you just have 60% in stocks and 40% in bonds, you’re missing out on a massive potential upside, and the market generally goes up. It has these really rough patches, and that’s where the strategy is to, when you have the rough patch, protect yourself, and that’s all that matters. You don’t need to trade around the little 5% or 10% wobbles. You just need to protect yourself against the 40% or 50% downturn. And Spitznagel has an interesting way of describing why those big downturns are so bad for the long-term performance of a portfolio. So let’s say you have a hundred dollars, and the market goes down 50%.

[00:35:27] Scott Patterson: You have lost $50. You now have $50. To get back to where you were, to $100, you have to go up 100 percent. So, down 50 percent, you need to get back even. You need to go up 100 percent. That’s why you don’t want to have that. It can take years, sometimes, to crawl out of that hole. And that’s what Universa tries to do: protect the investors from the big drawdowns, the little wobbles. The market will work itself through that stuff. And that’s kind of what Nassim, you know, I was talking to a risk manager, Aaron Brown, who has known them for a long time about. How Nassim, and Mark too, but mainly Nassim with his books, analyze typical Wall Street risk management strategies.

[00:36:19] Scott Patterson: Quant risk managers typically focus on the day-to-day risks and believe that managing those day-to-day ups and downs and optimizing the portfolio for them is what really matters. They might spend a little time thinking about black swans, the crashes, but those are largely seen as unmanageable. You know, what can you do? These things are crazy. You can’t think about that too much. However, what Aaron said and what Nassim showed is that the big drawdowns are really all you need to care about. If you can get through those, then you’ll be okay. Because if you can’t, you’re done, and you’re off looking for a new job.

[00:37:02] Clay Finck: It’s very clear that Taleb and Spit Snaggle just thought a lot differently, and they just viewed the world totally differently. And one of the things I always find interesting with people like these two is that oftentimes they’re very critical of some of the things that are taught in academia, such as the efficient market hypothesis or modern portfolio theory.

[00:37:27] Clay Finck: What were some of the things you found from these two when they were critical of what was taught in academia?

[00:37:35] Scott Patterson: Yeah, well, Nassim thinking is books. They’ve had a big influence on me, you know, for a long time. I came into writing about finance as a, you know, I had a master’s degree in English. I studied anthropology, had not studied economics or economic theory, but I started writing about finance in the late 1990s and started reading more about the theories behind it, the efficient market hypothesis, which we talked about.

[00:38:05] Scott Patterson: And these are sort of predicated on this idea of the rational man that’s sort of at the, you know, that goes back to Adam Smith, that economies are based on people acting in their self-interest rationally. And you get this sort of optimal economy when everybody’s doing that. And then this was taken by finance professors and applied to the market.

[00:38:30] Scott Patterson: So the market itself is always optimally efficient every second of the day because everybody’s sort of rationally pricing in their expectations of where stocks are going to go or whatever, commodities. And I thought that was crazy. I just, just sort of coming at it from a completely different perspective, having, you know, reading novels and stuff, like, I thought people are completely irrational.

[00:38:56] Scott Patterson: They don’t behave in insane manners all the time. And now you’re talking about financial markets where it’s people’s livelihoods that are at stake. And I looked at markets and I see fear and greed and fear and greed. When you think rational, that’s not, you know, so yeah, lots of times the market is acting pretty normally, but when Amazon is going to the moon, everybody piles in.

[00:39:23] Scott Patterson: It makes no money for years and years. Is that rational? You know, because stock prices are supposed to be projections of future earnings for investors. Amazon made no money for years and years. So, you know, somebody who I also read a lot was George Soros’ books, and he definitely does not believe in rational investors. He thinks that markets are driven by, you know, all sorts of strange factors that are sort of interconnected.

[00:39:54] Scott Patterson: And he would say Amazon, it wasn’t rational, but there was sort of this self-fulfilling prophecy. And what happened to that stock because the stock price goes up, the company can use that high stock price to buy other companies, compensate managers who might think that they can get a better deal at Amazon.

[00:40:15] Scott Patterson: But that’s not rational expectations. So, you know, when I met with Nassim in 2007, that’s when I got to know him. It really, what he was saying really clicked for me, the models that quantus are based on the bell curve things all clustering in the middle of the curve. You know, he was saying like, no, it’s the stuff on the back tails of the curve.

[00:40:42] Scott Patterson: That’s what really matters. But their models just cut that out. They just say, “No, we’re not going to worry about that 5% risk.” The, you know, we could lose all our money in a day.

[00:40:53] Clay Finck: Another interesting idea related to Taleb is the title of one of his books, “Skin in the Game.” You talk a bit in your book about how the lack of skin in the game in the financial system also leads to this increasing fragility in the overall market.

[00:41:12] Clay Finck: So, I’m curious if you could expand on this idea as well.

[00:41:17] Scott Patterson: Yeah, I think Nassim really developed that idea after 2008 when, you know, all of these very highly paid managers of banks and hedge funds, mainly banks, I think is what he was looking at, lost all the money and yet walked away with millions and millions in pay packages and were bailed out by the government.

[00:41:40] Scott Patterson: One person he likes to really focus on is Rob Rubin, who was chairman of Citigroup through the 2000s, and he got, I think, a hundred million dollars from Citigroup. And yet that bank collapsed and required billions and billions in bailouts. Nassim says that happens because these managers don’t have so-called “skin in the game.”

[00:42:02] Scott Patterson: So, which to him would mean if the bank collapses, the managers are on the hook for that. Personally, their own bank accounts are on the hook and will be required to help repay investors or clients. And he thinks, probably rightly, that if that were the case, they wouldn’t be taking all these crazy risks because they’re basically socializing the risk to the rest of the country by saying if I can take all these crazy bets year after year, I get a big bonus.

[00:42:37] Scott Patterson: Yeah, eventually it may blow up, but by then I’ve got my private yacht and island in the Caymans and I’m fine, you know, so. And I think that, you know, right now people are looking at these regional banks that are collapsing like Silicon Valley Bank and thinking the same thing. Like, you know, these managers, either they didn’t understand the risks they were taking or they made the gamble that it was worth it to hopefully get through any short-term volatility that they could get survive.

[00:43:12] Scott Patterson: Obviously, they didn’t, but, you know, the bankers are not on the hook for that. Taleb would contrast that with hedge funds, which often the partners of the hedge funds do have a significant amount of their own wealth in those strategies, and that constrains the risk they take. I don’t really know. I mean, I see a lot of hedge funds blow up, so I think that sometimes the greed side of the spectrum overcomes the fear side a lot, and, you know, they either don’t understand the risk or they just are sort of captivated by the potential returns that they can make.

[00:43:54] Scott Patterson: I think a lot of times they sort of back themselves into corners by, you know, sometimes hedge funds will have a good couple of years and then a lot of money blows in. And that becomes a lot harder to manage, and there’s just not a lot of good places. So a strategy that might have worked well for a hundred million may not work so well with two or three billion, and they start kind of looking around for places to chase the returns. They see some interesting derivative strategies that are attractive and are being pitched by Wall Street.

[00:44:35] Scott Patterson: They get into those, they start selling a lot of options to Universa to get those nice day-to-day returns. So, you know, I don’t know if it’s as effective with hedge funds as Nassim says, but I certainly think with banks when you have systemic risk and the “too big to fail” issue, it’s certainly something worth exploring. Some kind of clawback mandated and, you know, banks’ charter that if the bank fails, the top managers will give up x percent of their salaries from the previous five years or something like that.

[00:45:12] Clay Finck: To my understanding, when looking at Universa’s strategy, they kind of take the approach that these Black Swan events are totally unpredictable. We shouldn’t try to predict when or what year this is going to happen. I think if someone hears about the story of Universa making three or 4,000% throughout the COVID crisis, they think, “Oh, they just bet big on markets totally collapsing and they did it at the perfect time.”

[00:45:41] Clay Finck: So, I’m curious about your thoughts on how predictable these sorts of things are. Because I know you tell the story of Taleb, he saw a lot of the warning signs of COVID-19 in January 2020, and he was sounding the alarm bells, trying to wake people up to this, and then Bill Ackman saw a similar thing.

[00:46:04] Clay Finck: So, I’m curious about your thoughts on whether they are scaling up some of their bets when they see a lot more risk and where they’re at in terms of trying to predict these sort of tail-risk events.

[00:46:19] Scott Patterson: Yeah, Spitznagel would say that he never speculates. So there have been, you know, I mentioned Arnborg earlier. Another thing he told me was that when he looks at the strategy, he doesn’t see a way that it could perform as well as it does without dialing up that risk. You know, Mark says Aaron doesn’t understand the strategy. How could he? They’re a black box in a way. Like, you know, we don’t really know exactly what they’re doing, we just know what the returns are, which are quite phenomenal.

[00:46:56] Scott Patterson: But yeah, he denies that. He denies that they dial up, you know, try to make the bet bigger when they see something looming on the horizon because their basic perspective is you just can’t predict it. There’s no telling when it’s going to hit. If you keep doing that, you’re going to lose money for your clients over time. And he sees that as a losing strategy. It’s also hard to imagine a more aggressive strategy than Universa. You know, they’re betting on a 20% decline in the S&P in a month. They could say, “Okay, let’s bet on a 30% decline.” How much is that really going to increase the returns? You know, they might get some cheaper options. I mean, they’re already dirt cheap. They might get a little bit more upside.

[00:47:50] Scott Patterson: So when I think about it, it’s hard for me to really, they probably could do it, but it’s hard for me to think of a more aggressive, explosive upside strategy when they’re already employing. I mean, who knows? Mark says they don’t do it. I believe what he says. There are others who, you know, like Ackman, who try to take advantage of the situations. It’s in some ways like a gut trade. Like, they just feel something’s going to happen, and now’s a good time to trade. And that’s what Ackman does, right? I mean, he’s also a very good investor in companies. He understands, you know, what companies are good or bad. He, again, like many others, sort of models himself on Warren Buffett. So he’s looking for value, but he also makes these big bets. He did the same thing in the global financial crisis where he bet against some companies that were exposed to the housing market.

[00:48:55] Scott Patterson: But there have been other times, in these, you know, we don’t even hear about them, where he’s probably made similar bets and lost all his money. And that’s what happens with these trades—if the big event doesn’t happen, you make no money, you lose your entire bet. With the 2020 Covid bet, it seemed like a risk worth taking.

[00:49:19] Scott Patterson: You know, when you look at it in retrospect, I think it was 20 to $30 million that he spent on these derivative contracts that ended up giving a return of more than 2 billion. So yeah, that seems like a, you know, a pretty good trade to make. Not a lot of people did it, though.

[00:49:41] Clay Finck: I’m also curious because Taleb is such a student of wide-ranging subjects that are, you know, going on in the world. Have you talked to Taleb about what are some of the things he’s seeing in the world today that he thinks are risks that are just way overlooked by people? One that comes to mind that you talk about in your book is climate change. I’m curious if maybe Taleb sees something else outside of that too.

[00:50:13] Scott Patterson: I asked him about AI recently, and you know, obviously everybody’s talking about it, and people within the AI community are kind of freaked out. I came across a study, or it was a survey of AI programmers, I think from 2022 or 2021, and one of the questions was, “What is the risk that AI could lead to the extinction of the human race?” And 10% of those surveyed said that was a risk, which seems like a really high number. But Nassim said he is not that concerned about AI. I haven’t talked to him in depth about it, but he says it has local benefits, and to him, that’s a code word for not systemic, that it might have little areas where it causes some harm but doesn’t spread throughout the system. And that’s always something that he’s, you know, looking for in terms of a systemic risk that he’s worried about.

[00:51:15] Scott Patterson: So one area that he’s expressed a lot of concern about over the years is GMOs, genetically modified organisms, and he and some others wrote a paper about that seven or eight years ago called “The Precautionary Principle.” And this is something I delve into in the book, about that paper. It’s an interesting analysis because they sort of use this GMO issue as a way to create a model for looking at potential systemic risk.

[00:51:45] Scott Patterson: So it’s gotta be something that is interconnected with other systems, food systems, obviously with GMOs, something that can spread rapidly, something that has a global effect, global impact. Those are the kinds of things that he’s looking for that you would apply the precautionary principle to. And the precautionary principle is not something he made up. It’s been around for decades, widely applied in Europe, but not so much in the US. And the idea behind it is that if something does pose potential systemic risk to the human race, the people proposing that we do this thing have to prove that it doesn’t have that risk. So the onus is on the people doing it, and in this case, it would be on the GMO community. They are widely dismissive of such concerns. It’s an interesting debate. I just presented it as they outlined it in the paper, and I know the GMO people are very angry about it.

[00:52:49] Clay Finck: You say that the burden of proof relies on those who are presenting these various ideas, and whatever the idea is, it almost seems like an impossible task to prove that it’s not going to have a total systemic issue.

[00:53:05] Scott Patterson: Yeah, it’s a very daunting barrier. So, you know, if these risks are real, then I can see why there would be regulations against things seen as potentially systemically risky in Europe. GMOs are much less widely used in Europe, and even China didn’t allow GMOs in their food system. But plenty of others in America have been very open to GMOs. It’s worth thinking about. I can’t, you know, I’m not a genetic biologist or molecular biologist. And that’s an interesting thing because they address that issue in their paper. The precautionary principle is that experts will say, “Well, you’re not an expert, so you don’t get an opinion on this.” And they say, “Well, we’re not experts in this specific thing that you’re doing, but we are experts in risk and complexity and potential systemic breakdown and ruin problems for the human race. That’s what we know, and what you’re doing has some of these properties, and we think that you should consider it.” And the GMO people say, “Well, you’re going to condemn millions of people to death and starvation if we don’t pursue these GMOs.” It’s debatable because when you look at real issues of starvation and hunger around the world, it’s not the production of food that’s the problem. It’s the distribution of the food that’s the problem. There’s plenty of food being grown. It’s just that in war zones and conflict areas, it becomes very hard to get food to these people. I mean, China has a huge overproduction of food that, if distributed, would solve the world’s hunger problem. So anyway, it’s a debate. I never really had a strong view on GMOs until I read this paper. I don’t consider myself able to solve that particular conundrum. I see upsides and downsides. I also think that, as I say in the book, I think the GMO genie’s out of the bottle already. So we’re rolling the dice on that one and seeing how it goes. Hopefully, it’s not as bad as Taleb and his co-authors say.

[00:55:23] Clay Finck: Pivoting to talk more about systemic risks in the financial system, I think back to the Great Financial Crisis when total calamity and chaos struck, and then the Federal Reserve came to save the day, bailing out the banks and continuing to provide liquidity to the system for years after that.

[00:55:43] Clay Finck: So I’m curious if Taleb and Spitznagel are even more excited about their strategy today. Now that the Fed has provided so much liquidity to the financial system and interest rates have cranked up, putting a lot of pressure on the system. I’m curious about their general thoughts on the strategy today.

[00:56:04] Scott Patterson: Spitznagle and Taleb have both been predicting a complete systemic collapse in the financial system for decades, and we came very close in 2008 and 2009. Yeah, we were bailed out by Congress and the Fed. So, their view was a very, very extreme view, in my opinion: no bailouts. Let the banks fail. If you can stop the bleeding now, but the patient is still sick and we’ll just be sick until, you know, we face the reckoning and it’s just… The longer we wait, the worse it’s going to get.

[00:56:41] Scott Patterson: I totally disagree that the government shouldn’t have done what they did back then because, I mean, we were looking at General Electric failing. We were looking at the entire economy collapsing and hundreds of millions of people being put out of work around the world. So, I think that what was done was smart and necessary.

[00:57:04] Scott Patterson: I also think that the perpetrators were totally left off the hook. And these were people who were easily found, like, you know, people who were running some of these big housing companies, people in the banks that were trading, doing, you know, doing these strategies that lost billions. And their managers either were willingly or just oblivious.

[00:57:27] Scott Patterson: There should have been—I agree with Taleb. He had a debate with Larry Summers in 2014 or 2015 at a conference, and Larry Summers was one of the architects of the bailout, you know, the Obama administration. And he was defending it. He was saying, you know, we’ve improved capital standards for the banks, you know, they’re safer now.

[00:57:51] Scott Patterson: And Taleb was like, yeah, but you know, the problem is still there. And Summers just said, well, what are you for? And Taleb says, I’m for punishment. So, I agree with them on some of those things. It’s a very harsh view to say, just let it all collapse. And that partly comes from their very negative view of government intervention, libertarian views, especially Mark.

[00:58:17] Scott Patterson: So, they kind of see anything the government does as just going to make things worse. You know, so it’s created this system where the financial markets are just sort of floating on all this free money. It can’t last. The natural order is eventually going to impose itself, and no matter what the Fed is going to try to do, it’s going to roll right over it.

[00:58:44] Scott Patterson: So, he’s expecting, and he’s recently written, that the system is sitting on a time bomb that’s going to explode. He won’t predict when because he doesn’t predict timing things. He thinks it can keep going for years, but he does expect it to blow up catastrophically, and that’ll be good for universities.

[00:59:05] Scott Patterson: I think they talk about one of their main risks is that the banks aren’t around to pay up when their trades are successful, that the system just completely collapses, which should just be bad for everybody. But that’s, no, that’s, we’re talking about like back to caveman days.

[00:59:25] Clay Finck: That is another thought that comes to my mind when so many families and so many people are suffering in a downturn, and people are losing their jobs and such massive unemployment.

[00:59:38] Clay Finck: If the authorities see a company, you know, making billions upon billions in the face of this calamity, you know, part of me thinks the rules are just going to change, and somehow, one way or another, they’re just not going to get the payout that they thought they were going to get.

[00:59:59] Scott Patterson: I guess you never know. I mean, one thing you gotta remember with Universa is they’re protecting investors against these calamitous events, including pension funds. So it’s not just like they’re pirates that are, you know, raiding, raping, and pillaging and making money on other people’s misery. They’re actually helping their clients, which includes pensions and retirees. That said, you never know what regulators are going to do. I’ve never heard of any threat because they’re just, you know, they’re trading on open markets. It’s very transparent stuff. I would say, if you look back at what happened in the global financial crisis, there were firms that created brand new trading strategies and derivatives that were expressly designed to benefit from a blow-up in the housing market. It was entirely new. You know, several of the big money center banks created these things, these swaps. And if those hadn’t existed, the disaster wouldn’t have been as bad. But you know, at the same time, it’s hard to say. They weren’t really doing anything technically illegal. They were just creating these instruments that other parties happily sold them, and they made a lot of money on it. But you never know. I mean, regulators can be unpredictable, that’s for sure.

[01:01:23] Clay Finck: Well, Scott, this is a really fun conversation. I loved reading through your book, “The Chaos Kings,” newly published around the time that this episode is going to be going out. So, thank you so much for joining me. Before we close it out here, I wanted to give you the opportunity to give a handoff to whatever you’d like and where people can find the book.

[01:01:49] Scott Patterson: Yeah, sure, they can find it on Amazon. I have a website, ScottPattersonBooks.com, and they can find me on Twitter at @pattersonscott.

[01:01:58] Clay Finck: Scott. Awesome. Thank you so much again, Scott. I really appreciate it. 

[01:02:03] Scott Patterson: Thanks a lot, Clay. 

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