Nonlinear Losses, Linear Lies

Where else in our financial system might complex mathematical modeling be used to cloak risks? It has happened in mortgage-backed securities (MBS) before, most notably during the 2008 crisis. Because we so poorly diagnosed the root causes of that crisis, it can happen again.

Nassim Taleb illustrates this hidden fragility with the example of Fannie Mae, whose internal risk reports showed exposures that were “severely concave.” A small adverse shift could trigger outsized, accelerating losses, while favorable conditions brought meager gains. 

This is negative convexity in action: a system primed for collapse.

Subprime auto ABS exhibits similar features. Extending loan terms made payments look affordable, but it also created fragility. 

Once car values declined and delinquencies rose, losses cascaded through the structure. The downside proved exponential, the upside capped. 

Twain’s Duke and King never stayed in town long enough to face the reckoning, but Wall Street’s products linger until defaults reveal the structural rot.

The speed of the Tricolor collapse reveals the brittle nature of these structures. When trust evaporates, mathematical models become irrelevant. Investors discovered that their “bankruptcy remote” securities were anything but remote from the bankruptcy of their servicer. 

The careful tranching, the credit enhancements, the structural triggers – all proved as illusory as the Duke’s royal bloodline once the underlying data was revealed to be fiction.

Skin in the Game, or the Lack Thereof

Another of Taleb’s enduring themes is the agency problem. Financial engineers and executives can pocket bonuses while offloading tail risks onto shareholders, creditors, or taxpayers. “They had no skin in the game,” Taleb insists, making their incentives asymmetric. Gains are privatized; losses are socialized.

The Duke and King embodied this thoroughly. They risked nothing but their reputations, while townspeople risked their wallets and pride. When exposed, the swindlers skipped town, moving on to the next gullible audience. 

Similarly, Tricolor’s creditors – big banks and asset managers – now face losses, while the executives have already taken years of compensation.

The asymmetry in the Tricolor case is particularly stark. While banks and bondholders face hundreds of millions in losses, the company’s founder, Daniel Chu, and other executives collected fees and salaries for years before the scheme unraveled. 

Tricolor’s bankruptcy filing lists more than 25,000 creditors, from sophisticated Wall Street firms down to a Texas towing company still waiting to be paid for hauling away repossessed cars. 

The very structure of the securitization markets often misaligns incentives. 

Originators like Tricolor sell loans quickly to investors, removing their own capital from risk while retaining servicing fees. 

Rating agencies are paid by the issuers they rate. 

Trustees and backup servicers collect fees regardless of performance. 

As one restructuring attorney noted, “someone’s going to lose” – but it’s rarely the architects of the system. 

Real, lasting financial reforms that align incentives might temporarily dent the Dow and risk losing Congressional seats in the next election. 

“Better to pressure the Fed to ease and the banks to extend and pretend,” figure the hirelings who are too common in the halls of political power.

The Seduction of Sophistication

Twain showed how ordinary people can be dazzled by a veneer of culture. The King’s ridiculous Shakespearean recitations persuaded his audiences that they were witnessing something refined. 

Likewise, structured products carry the aura of sophistication. Ratings agencies certify them. Spreadsheets project cash flows with precision to the decimal point. Conferences are filled with jargon about tranching, convexity, and correlation.

Yet the underlying reality may be as flimsy as the Duke’s stagecraft. When defaults rise, correlations spike, and investors suddenly realize that their supposedly diversified pools of loans are all exposed to the same macroeconomic risks. 

Complexity is not sophistication. Often, it is a mask for fragility.

The Reckoning

In Twain’s tale, the Duke and King get their comeuppance. A mob tars and feathers them, leaving them to float off in disgrace:

“I told Tom [Sawyer] all about our Royal Nonesuch rapscallions, and as much of the raft voyage as I had time to; and as we struck into the town and up through the middle of it – it was as much as half-after eight, then – here comes a raging rush of people with torches, and an awful whooping and yelling, and banging tin pans and blowing horns; and we jumped to one side to let them go by; and as they went by I see they had the king and the duke astraddle of a rail – that is, I knowed it WAS the king and the duke, though they was all over tar and feathers, and didn’t look like nothing in the world that was human – just looked like a couple of monstrous big soldier plumes.”

Huck watches, shaken but wiser. “It was a dreadful thing to see,” he admits, but justice demanded it.

For Tricolor’s investors, the reckoning has already begun. Senior tranches that looked ironclad now trade at distressed levels. Junior investors, once flush with optimism, hold paper worth pennies.

The scramble for assets resembles nothing so much as Twain’s townspeople realizing they’ve been had. 

In Dallas, Triumph Financial employees dashed through used-car lots, trying to identify which vehicles actually belonged to them. 

In Manhattan, Clear Haven, a bag holder in this story, could have been more skeptical of Tricolor’s underwriting process.

Blair Adams, a Clear Haven representative, said in a statement to Bloomberg that the firm “and other investors in asset-backed securities issued by affiliates of Tricolor are focused on protecting the integrity of the bankruptcy remote collateral structure in which they invested and ensuring that the non-debtor trusts do not become collateral damage in Tricolor’s bankruptcy.”

It’s a phrase that reflects the realization of the townsfolk who the King and the Duke conned.

Meanwhile, Wilmington Trust, the independent trustee, has scheduled calls with panicked bondholders who didn’t receive their expected payments. 

Federal prosecutors are now investigating, but the damage has already been done. The cost of unwinding the mess may consume whatever value remains, just as legal fees devoured recoveries in previous subprime auto loan bankruptcies, such as American Car Center and US Auto Sales.

The broader question is whether this is an isolated humiliation or, like Twain’s con men, merely one act in a longer show of deception.

I caution you against assuming isolation. In a world of tightly coupled systems, fragilities compound. Small defaults can cascade, especially when hidden nonlinearities and agency problems align. What appears to be an outlier may, in fact, be the opening scene of a larger drama.

Already, the contagion is spreading. Credit spreads on other subprime auto deals have widened as investors reassess what they thought they knew about due diligence and oversight. 

Fast-growing subprime lenders with similar business models find themselves under sharper scrutiny. The faith in mathematical models and structural safeguards has been shaken, and once trust erodes in credit markets, it proves difficult to rebuild.

Huck’s Lesson

Twain used satire to expose human folly. Taleb uses mathematics and philosophy to reveal hidden fragilities. Both converge on a timeless truth: risk cannot be wished away; it can only be misrepresented. 

The Duke and King’s audiences paid dearly for their gullibility. 

Today’s investors risk making the same mistake by confusing structured complexity with true resilience.

As Huck Finn might put it, it’s “enough to make a body ashamed of the human race” to watch the same mistakes repeat. 

But perhaps by seeing through both the stagecraft of Twain’s rogues and the mathematical veils Taleb warns against, we can learn to spot the next con before the curtain rises.

Most structured products, including ABS and MBS, are properly underwritten. They will perform as promised. However, it’s been a long time since the last debt default cycle, so stay vigilant. 

All it takes to avoid getting into investments like Tricolor is to ask a few critical questions about where the money is coming from to fund your expected payouts – whether your payout is coming from stocks, bonds, or any other security trading in public markets.