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Black swan unfolding – bond re-insurers – and what it means for startups

By January 22, 2008 2 Comments

On Friday last week Friday Ambac, one of the largest bond insurers was downgraded by Fitch Ratings.  This is undoubtedly bad news for the world economy and stock markets took another pounding yesterday.  You can read more about it in the FT.

I am reading Taleb’s Black Swan at the moment and I’m finding that it is a hard concept to get across to people, so when I started thinking that the crisis at bond re-insurers was a good example I wanted to capture it here.

To set the background, first, Taleb’s definition of Black Swan:

a black swan is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations

Second, a bit about bond re-insurers.  These are big financial services companies which lend their high credit ratings to smaller companies who can then raise bonds more cheaply.  Effectively the bond re-insurer guarantees the bond which makes the loan less risky and reduces the interest rate.  They run models that predict default rates on the bonds they insure and make sure they have sufficient capital to cover all likely eventualities.

Ambac and the others will have looked at their models and convinced themselves they were safe under all but the most unlikely of events.  They probably even used language like ‘3 sigma event’ to describe the kind of thing that would have to happen for enough defaults to come in at once to get them into trouble.

Yet that is exactly what has happened.

This hard to predict, rare event (multiple concurrent defaults) is now having a massive impact.  The stock markets are falling because the Ambac rating downgrade, and mooted downgrades for other bond re-insurers, could force banks to write down the value of the bonds they hold triggering further massive losses and capital raisings.

This is in large part a story of building risk models and calculating exposure in one world (pre sub-prime collapse) and then finding that the assumptions no longer hold.  The inter-connected world we live in makes this sort of thing increasingly frequent and increasingly hard to predict.

The good news for VCs and entrepreneurs is that black swans work both ways.  As well as negative destructive black swans there are positive ones too, and these often take the form of startup companies.  Taleb cites Google as an example.

Putting yourself in a position to benefit from one of these is potentially a highly lucrative business.  Spotting opportunities that were highly unlikely to come off, but are becoming less so and having the courage to back them early is one way of doing this.  Ironically going after Google’s seemingly unassailable position in search today might just be one of those.  I’m also reminded of Bob Young’s description of how everyone thought he was crazy when he founded Red Hat to take on the dominant position of IBM, Sun and others in the Unix market.

Thinking about it, this line of thought goes a long way to understanding why successful entrepreneurs often seem to be the ones who like taking on seemingly impossible tasks.

The other implication of this is that it pays to put yourself in the position to be lucky.  Which reminds me of the old venture cliche about failing often, but doing it fast.