Most Americans consider themselves patriotic and are proud to be American. But there are differences when it comes to “intense expressions” of patriotism, according to a new national survey by the Pew Research Center for the People & the Press. Many who consider themselves very patriotic and proud of the U.S. are also highly critical of the federal government and politicians.

According to Pew, “more than eight-in-ten (83%) say they are either extremely proud (52%) or very proud (31%) to be an American. Just 14% say they are moderately proud (8%) or have little or no pride (6%) in being an American.”

If you look below, you will notice that whites, males, Republicans, older people and Obama critics are the most likely to be proud to Americans.

Free Market Mojo is proud to present an interview with Kenneth A. Posner, author of Stalking the Black Swan: Research and Decision Making in a World of Extreme Volatility and a former financial services analyst.

Currently involved in a start-up company seeking to invest in the US financial services industry, Ken Posner spent 15 years at Morgan Stanley, where he was managing director, senior research analyst, and head of the financial services research team. The stocks he researched included Fannie Mae, Freddie Mac, Countrywide, American Express, Discover, MasterCard, CIT Group, and others in the so-called “specialty finance” industry, one of the most volatile segments of the financial services sector. His work received high rankings from Institutional Investor and Greenwich Associates.

A graduate of Yale University and the University of Chicago Graduate School of Business, he has also earned the Certified Public Accountant, Chartered Financial Analyst, and Financial Risk Manager designations.  Posner has recently published op-eds in the Washington Post, Financial Times, and Fortune on topics including Goldman Sachs’ response to the SEC lawsuit, choices in reforming Fannie Mae and Freddie Mac, and the use of “contingent capital” to automatically recapitalize systemically important financial institutions during a crisis.

As with our other interviews, the author’s views are his own and are not necessarily endorsed by either author of Free Market Mojo.

FMM: Could you provide a brief overview of Stalking the Black Swan?

Posner: The idea behind the book is that we live in a world of black swans, which is the term that Nassim Taleb has popularized to refer to seemingly unpredictable surprises that end up having huge impacts. One example would be the global economic downturn that we have been suffering through as a result of the housing crash in the U.S. But there are many other black swans out there. They don’t have to be global crises. The flash crash from a couple weeks ago is another version of a black swan.

And in the book, every chapter has one or more examples. I start out the book with the story of a credit card company that was a high-flying darling of Wall Street and a growth stock and two months later it lost ninety-five percent of its value, so that’s a black swan that affects an individual company.

What I try to do in Stalking the Black Swan is go beyond just the idea of the black swan, as Taleb has already discussed that. I try to offer some decision making strategies that can help people—whether they are individual investors or professionals or regulators or CEOs or directors—make decisions in a world that happens to be extremely volatile from time to time.

FMM: Why do black swans go undetected for so long? What are some of the ways in which your research allows us to see them coming, or at least react to them in a better fashion?

Posner: The book offers a multidisciplinary approach. I start by emphasizing fundamental research, which is a discipline that we all associate with Graham and Dodd and Warren Buffet. Sometimes people think of fundamental research as being about ratios or valuation, but I argue that it’s really about figuring out what causes events to happen. Sometimes people don’t dig deep enough to discover the underlying causes.

On the other hand, in today’s world, computers are getting evermore powerful. So there are quant tools that we can use to help us understand complex situations.

And then finally I integrate psychology, because our most powerful problem solving tools are our brains, which are actually substantially more powerful than even the fastest computer is. Understanding the strengths and weakness of intuition and judgment, I think are critical, and that is what some of the risk management profession and the regulators lost sight of in their embracing of value at risk and other tools.

But to answer your first question, why are some of these black swans effectively unpredictable? Well, the world is complicated, and so we can’t know everything. That’s the simple answer. But, it is also important to understand—and this is particularly important for financial and regulatory reform—that we operate in market economies. No body is in charge, and nobody knows what everybody else is doing.

A credit cycle, like the one that affected the US, emerges because there is a time lag between when a market starts to impact home prices or other asset values, and the time in which the market finally understands what it has done. In the U.S., the securitization markets probably started to impact home prices in 2003, and it wasn’t until 2007 that the securitization markets finally shut down in horror at how much bad lending they had actually facilitated.

There is no way for everybody to understand what everybody else is doing, so these kinds of surprises are unfortunately inevitable from time to time.

FMM: Moving on to the financial crisis, I would like to talk briefly about your career as an analyst. You focused on the specialty finance sector. Can you talk briefly about what this sector does, and how your knowledge of it gave you an insight into our financial crisis?

Posner: The specialty finance sector consists of financial institutions that aren’t banks and therefore depend on market funding. It is a riskier kind of balance sheet and the companies in this sector tend to have a specialty focus on certain asset class whether its mortgages or credit cards or student lending or payday lending or aircraft leasing. That is basically what the sector is. The biggest names in the sector were Fannie Mae and Freddie Mac and Countrywide on the mortgage side or American Express or Discover on the credit card side.

This sector is probably the most risky sector in the financial services industry. As I mentioned earlier, I saw black swans affecting individual companies often associated with bad underwriting of loans as far back as the late 90s and early 2000 period. And then I did have ground zero seat on the U.S. housing crash because of Fannie Mae, Freddie Mac, Countrywide and other mortgage companies. I was watching them and they were using the processes and models they had at the time to gauge the risks in the housing market and I saw it all go wrong and therefore have at least some understanding of where the mistakes or the flaws in decision making were that led to such spectacularly bad outcomes.

FMM: Blame has been spread almost everywhere for the financial crisis. In your opinion, which entities, events or decisions are at the core of our current economic predicament? How do we not make these mistakes in the future?

Posner: I think there are a lot of people and institutions that deserve blame, and people should be held accountable. I think that’s all fine and there is plenty to go around.

There are many reasons for the crash, but I want to highlight one reason in particular. And that is the decision making that I refer to, because the fact is that we live in a world in which computer power is accelerating. Processing speed bandwidth, memory, it’s all growing exponentially and that means our world is changing very quickly. We are all dependent on higher power quant tools.  They affect every aspect of our life.

And so here is one area where the quant tools went wrong. And I think that is one of the big takeaways from this crisis. Let’s, for example, talk about the bank for international settlements and the Basil Capital Accord, which defined capital standards for banks. There was a big problem in this approach to setting bank capital standards. What they did was use statistical models, and they required banks to study past credit losses for different asset classes and set their capital levels accordingly.

That actually sounds sensible, doesn’t it? But what happened was that the banks all looked at the history, and the history of mortgages was that mortgages were a low risk asset class, so the banks accordingly, under the Basil rules, assigned very low capital ratios to mortgages. Since the capital ratios were low, the banks plowed into mortgages. They poured so much capital in that what used to be a low risk asset class became a very toxic asset class.  So the lesson is that when you use statistical modeling, when everyone follows the same model and looks at the same historical data, you can in fact have collective action that brings about a complete break with the past.

Basil made that mistake, and as a result European banks in particular were running around with leverage ratios of fifty to one, so they were not in a position to withstand the crisis, and that was part of the problem. And I mentioned Countrywide and Fannie Mae and Freddie Mac, they all made many mistakes and so did the rating agencies, and guess what? They all used the same models!

Back to the question of blame. Were there people who were greedy or stupid or asleep at the switch, and should they be blamed? Absolutely. But what we are also seeing is that a common decision making process based on quant models produced collectively an answer that was totally opposite from what people expected, that is one of the lessons of the crisis. Because we operate in market economies and in some cases everyone is doing the same thing, we need to be very careful about how we use these models.

FMM: You mention sources of excess volatility. Can you speak on some of the primary sources of excess volatility? Which ones most easily go undetected by analysts? Where do you see black swans appearing?

Posner: Let me give you three quick sources. And the one we just talked about, when everybody shares the same belief of follows the same process, as in those quant models, that can produce a black swan outcome because when everybody does the same thing, there is just huge leverage to that process.

But another source of black swans is debt, or financial leverage. I think people understand that debt is good, because it allows us to finance businesses and activity, but too much debt can be risky. One of the sources of black swans would be leverage, particularly hidden leverage. We saw that in the financial crisis. I don’t think most people appreciate the leverage implicit in CDOs or CDO-squared or the SIVs that banks used to hold assets off balance sheets.

Today, I like to remind people that Fannie Mae and Freddie Mac and the Federal Home Loan Bank System are like off balance sheet liabilities for the U.S. government. They don’t issue U.S. treasuries, they issue something called U.S. Agency Debt, but since those companies have basically no equity left, and it’s about $3 trillion of this stuff, it is really a liability of the U.S. government and the tax payer.

If we want to make our system a little bit less risky and a little bit less vulnerable to future black swans, myself and others have suggested that we put Fannie and Freddie into runoff and start to pay down that debt.

One more source of black swans, and I mentioned fundamental research earlier, getting at the underlying causes of things, sometimes the philosophies or strategies of a management team at a company can have significant consequences and that is why one of the chapters in the book is about techniques for interviewing management teams and getting at the underlying issues which they may or may not openly disclose.

FMM: What is your opinion of the proposed financial overhaul bill that is being considered by Congress? Are there any elements to it that you would add or subtract? What would be the long-term consequences if it is enacted?

Posner: Unfortunately I don’t really see a lot of effectiveness in the legislation. I am sure there are many small things in there that are all sensible like giving more derivatives onto exchanges, but the big ideas that banks should not be aloud to trade for themselves or that maybe they shouldn’t do derivatives, I don’t think that’s going to do anything at all.

The world is volatile and you can’t wish the volatility away or think you can make it go away by coming up with rules about what people can or cannot do because if the banks don’t do it, somebody else will and someday else is probably not regulated. So I just don’t see that as constructive at all.

What I would rather see in the financial reform legislation would be some measures that improve the responsiveness and resilience of the system by giving regulators the power to step in and clean up a crisis quickly and without using taxpayer funds. So I think the stress tests that they did last year were very effective and I would like to get those stress tests enshrined so that the regulators know to do that more frequently.

Secondly, there is an idea that I just don’t think has gotten enough airtime with the politicians: The very elegant idea that a number of smart people are suggesting, the idea that is called contingent capital.  The idea is to make the big banks like Citigroup and Goldman Sachs issue a certain amount of debt that would automatically convert to equity in a crisis so that if they got into trouble, that debt would automatically convert giving them enough equity to stabilize their situation. The losses would be borne by debt holders, not by taxpayers.

Now I don’t think this will solve all of our problems, but it is an example of something that would be like a “shock absorber” and it would make the system quicker to react to a crisis, and the faster we can react, the faster we can get on our way to recovery.

FMM: What is your opinion of Ben Bernanke and the Federal Reserve system’s handling of the crisis?

Posner: Clearly it was ad hoc, but the TARP and the stress tests together stabilized the system without too much damage. So I guess given how surprised everyone was, I would give them okay marks. Although I think the contingent capital idea would allow you to stabilize things without putting so much taxpayer funds at risk.

But let me say something about the Federal Reserve chairman position. Hopefully we will get the most competent people in the country to take on that responsibility, but I think we should be very careful before assuming that the Fed can save us from volatility or economic crises. I think we should be careful about putting too much trust in the institution or the personality of whoever happens to be the chairman.

I have suggested that the term limits for the Fed chairman be shortened. I think that if we rotated the chairmen or chairwomen more frequently people would be less confident that they could predict exactly what the Fed would do. And that would actually be healthy because less confidence, less belief that the Fed can always save us would cause people to hold a little bit more capital and take a little bit less risk, and I think that would be healthy for the markets and the economy.

FMM: It’s like a large safety that maybe encourages too much risk.

Posner: That’s right. People believed in the “Greenspan Put” in part because Greenspan had been there for fifteen or seventeen years and he had always been so successful in cutting interest rates to stave off problems, but that strategy outlived its usefulness.

If we were rotating the chairman position more frequently, I think it would be less likely that the institution would get stuck in a rut and stick with the strategy too long.

FMM: Some economists, such as Don Boudreaux, professor of law and economics at George Mason, have advocated for the abolishment of the rules that prohibit insider trading. Boudreaux argues that allowing insiders to act on their knowledge would more closely align stock prices with the actual value. What is your opinion of this view?

Posner: Without having spent a lot of time thinking about it, I do think that when insiders trade, that is a useful signal and I know investors and analysts pay a lot of attention to insider transactions.

I think the key thing is just to make sure that the insiders’ trades are disclosed. I think there is a question when they have material nonpublic information that has not yet been disclosed to the market, maybe it does make sense to let the market become aware of what the issue is before they trade. But they key is disclosure.

There have been some situations where CEOs have established programs where they can gradually sell off their holdings for diversification reasons. And I know there have bee cases when that wasn’t completely understood by the market, and I think that’s not good.

FMM:  The Gulf oil spill is certainly going to have ramifications for the oil industry and Gulf Coast economies. What kind of repercussions might we expect for the markets and the economy in general? Is this going to deal yet another blow to our already fragile economy, or will we see this primarily impact the relevant industries?

Posner: I think the Gulf oil spill is really astonishing as to how big it is. And I think it is a real tragedy for the people who live in that area, and they are businesses, not to mention the wildlife.

Having said that, I don’t think the total magnitude of the economy that is affected is big enough to really set the U.S. back. For all the damage that is done, people will vigorously attack and rebuild, and there will be payments of some sort from BP and/or insurance.

So again, it is a tragedy for the people involved, but I don’t think it is big enough to really set the U.S. back from our slow and gradual recovery. I hope I am not being too optimistic, but that’s my assessment, at least for now.

FMM: Well hopefully you are right.

Posner: Well I hope so. Because the U.S. has a lot of debt right now, and our debt is growing, we are in a riskier situation and so shocks are going to have a more severe impact on us than would be the case if our budget was in balance and we had the equivalent of a lot of reserves.

I am not much of an expert on China, but if China were to hit a speed bump that would have much bigger ramifications for the global economy and I wish we had a stronger financial position just to be ready for those kinds of surprises.

FMM: What role should the government play in protecting investors from black swans?

Posner: The government can do some things, but it can’t do everything. I think the worst thing in the world would be for people to think that the government can prevent volatility or protect us from the future unknowns. I think that would be a very unhealthy attitude. As I mentioned a second ago, even the belief in the “Greenspan Put” contributed to making this crisis more painful than it might have been otherwise.

But having said that, there are definitely some things that the government can do that individuals can’t. One of the things that the government can do is push for greater transparency and disclosures and consumer protections in those areas where consumers have a hard time understanding the nuances of complicated transactions. I think that is all very appropriate.

Remember, disclosure is an ever-changing landscape because the world grows; it gets bigger and more complicated. Transactions change so that disclosures you need are constantly changing, so that is a very important area. The regulators have actually been helpful in that regard in the past, at least in my experience.

I think the second area where the government can be helpful is in stepping in to clean up the mess. So that is where the idea of the contingent capital comes in or the stress tests or the ability to close banks or other financial institutions. The faster we can clean up the mess, the faster we can get on to recovery. So I think that is also a critically important position.

The last thing I would say; the government is us, right? So we will elect our representatives and I think we all need to look in the mirror and be careful about wishful thinking. Wishful thinking us also a source of black swans, and that is where inflation and asset bubbles can sometimes come from as well.

So back to Fannie Mae and Freddie Mac, I think as voters, we should ask ourselves, “Is that really the right way to subsidize housing?” and “Can we oversubsidize housing?” I think we did. We turned the American dream into, unfortunately, the American nightmare. So we need to avoid the government subsidizing or excessively subsidizing asset classes because that could cause problems.

But mostly transparencies and cleaning up the mess, and when we ask too much of the government, that is dangerous.

FMM: What do you hope readers will take way from your book, and what impact would you like it to have?

Posner: Not everybody is going to read the book and run out and start running Monte Carlo simulation models, nor should they. So that is not the take away. Not everybody is going to start sketching out probability trees or things like.

If people recognize the risks of black swans, then I think everybody should wake up in the morning and not be terrified or overwhelmed, but just understand that as our world grows and becomes more complicated and more interconnected, we are going to have more episodes of potentially extreme volatility.

And by the way, this volatility is also a source of great change and great progress. As I point out in the book, not all black swans are bad. Stock tripling in a year would be an example of a good black swan.

So just understanding that we live in this world, I think people can start making better decisions. It doesn’t have to be about picking this stock or that, it might be about trying to save a little more, or being a little more careful with debt, but a recognition that volatility is part of our life, it is not something we can wish away, it is not something the government can make go away. I think that kind attitude would be really constructive and helpful. With that attitude, we would be positioned as a nation or individually to reap the benefits of progress without getting blindsided and steamrolled when the volatility turns the other way.

FMM: Thank you for your time.

Posner: Thank you.

We would like to thank Mr. Posner for his time and wish him well in his future pursuits.

Click here to view other Free Market Mojo interviews.

The American Academy of Arts & Sciences has published an interesting article on the relationship between scientists and the public. Rather than blaming an “ignorant public,” the article blames scientists and engineers for a improper understanding of how to communicate with non-technical people.

According to science journalist Chris Mooney, scientists and the public often have “very different perceptions of risk, and very different ways of bestowing their trust and judging the credibility of information sources.”

“Perhaps scientists are misunderstanding the public…due to their own quirks, assumptions, and patterns of behavior,” Mooney writes. The public, meanwhile, tends to “strain their responses to scientific controversies through their ethical or value systems, as well as through their political or ideological outlooks.”