Soros Weighs In

Drudge links to a Financial Times contribution by George Soros:

In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences.

For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come... The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

How could Lehman have been left to go under? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve... they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is, they allowed it to happen.

On some level, Soros is likely correct in arguing that we would have been better off had US authorities bailed out Lehman. Concretely: if, the subsequent TARP would, then, have been avoidable, it would have been quite the good deal for tax-payers.

The dynamic, however, bears scrutiny. There are many reasons why Lehman's failure froze the financial system, but Soros describes a key one: The general expectation by market participants that financial authorities would save Lehman. In as much as past Government actions justified that expectation, Soros is correct in blaming authorities for the panic that ensued when they did not live up to to the expectation they had a strong hand in setting. I would think he is somewhat wrong in arguing that the crux is the not-meeting, as opposed to the setting-of, that expectation.

From a public-interest perspective, I think it is easy to argue that we are much better off when participants in our financial markets are speculating financially and economically (e.g.: over the strength of this or that business) as opposed to politically (e.g.: over whether the government will do this or that). It is, then, against the public interest for Government to engage in behavior which encourages the latter over the former.

On a deeper level, too, credit default swaps played a critical role in Lehman’s demise. My explanation is controversial...

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse... The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds.

By "controversial", he must mean, simply (and, given the source, astoundingly) "untrue".

It is true that in as much as a stock price can theoretically rise infinitely, shorting a stock entails theoretically infinite risk. On the other hand. it is not at all true that selling CDS entails unlimited risks. Selling CDS is, fundamentally, the same as selling insurance. A seller of CDS has no more "practically unlimited risk" then a seller of life insurance. More to his point, the price of CDS no more exaggerates a company's likelihood of default then the price of life insurance exaggerates the likelihood of one's premature demise.

When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.

It is unclear to me how he is arguing buyers motivations affects the sellers (or any) risk. If a buyer purchases CDS without expectation of default, and the underlier defaults, that is a bonus. Conversely, a seller has no business writing CDS without expectation of default.

No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

It is certainly true -- and not particularly difficult, to my mind, to grasp -- that efficient market hypothesis is limited by the laws of supply and demand.

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust.

That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other.

What, most directly, brought Lehman down was the market's reluctance to lend to it and the threat of rating agency downgrade. Prospective lenders and raters were certainly scared off by falling stock and rising CDS prices that indicated the markets increasing expectation of a Lehman collapse. Assuming Soros' "controversial" position that lenders and raters mis-read the information in those prices, its still a rather odd argument that Lehman was destroyed by "bear-raid". In the end, Lehman was an obscenely levered company and, as such, heavily dependent on near complete confidence and trust. It is hard to sensibly argue that it was Lehman's falling stock and rising CDS price, and not its manifestly atrocious performance that cost it the needed confidence and trust. The bear-raiders, then, were the opposite of "self-validating", they did what investors are supposed to do, expose an emperor with no clothes.

Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising).

I don't have a strong opinion on the matter, but when the S.E.C. removed the uptick rule it did so on the basis of research indicating its purposelessness.

That is what AIG, one of the most successful insurance companies in the world, failed to understand. Its business was selling insurance and, when it saw a seriously mispriced risk, it went to town insuring it, in the belief that diversifying risk reduces it. It expected to make a fortune in the long run but it was destroyed in short order.

The primary difference between selling CDS and selling insurance are the collateral obligations. If I buy insurance, I know that the seller is subject to all sorts of regulatory requirements that give me confidence that it will be able to meet its obligation to me. If I buy CDS, I have no such assurance. Instead, I require collateral. The higher the price of the CDS, the more collateral I require. In other words, with ordinary (e.g.: car) insurance, the seller only pays out in the case of an event (e.g.: an accident), with a CDS the seller pays out in based on the markets expectations of an event. Given that and the reality that when one company defaults, the likelyhood of other companies defaulting tends to increase, the sort of diversification strategy which works well for ordinary insurance will not work well for CDS.

In the end, as it was the inability to post price-based collateral, as opposed to inability to make payments that did in AIG, Soros' argument that AIG "saw" mis-pricing to profit in the upward bias of CDS prices baffles.

...What would have happened if the uptick rule on shorting shares had been kept ... and speculating in CDS had both been outlawed? The bankruptcy of Lehman might have been avoided but what would have happened to the asset super-bubble? One can only conjecture. My guess is that the bubble would have been deflated more slowly, with less catastrophic results, but that the after-effects would have lingered longer. It would have resembled more the Japanese experience than what is happening now.

The analogy to Japan is telling. The Japanese banks, after all, were failed banks that, with the support of the government, limped along. To compare the American banks to the Japanese banks is to implicitly acknowledge that ours too are failed banks, destroyed by their own incompetence and mismanagement and some not "self-validating bear-raid".

...What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but – in light of their asymmetric character – not to speculate against countries or companies.

Again, even if Soros is correct, this is (yet) another odd argument. If the market saw in the price of CDS a greater loss of confidence then really took place, the most straightforward solution would be to demonstrate that such that in the future the market would be better able to understand the information embedded in the price of CDS. Perhaps it is because Soros know that his "controversial" argument will not be well accepted by the market, that he advocates it being imposed.

The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.

It can be done – by creating money to offset the contraction of credit, recapitalising the banking system and writing off or down the accumulated debt in an orderly manner. They require radical and unorthodox policy measures. For best results, the three processes should be combined.

This is all sensible up to a point. If it were simply "toxic" derivatives which caused the current meltdown, then the steps Soros describes including the re-capitalizing the banking system plus limiting the use of these derivatives are all that is called for. If however, the root cause of the melt-down is deeper and more systematic, without addressing it, we are headed for of wash. rinse. repeat.

...In addition, banking regulations need to be internationally co-ordinated. Market regulations should be global as well. National governments also need to co-ordinate their macroeconomic policies in order to avoid wide currency swings and other disruption.

This is rich.