The person Paul C has cited as a contemporary example of parasitism
offers his advice on how to reform the capitalist world economy
below.
In solidarity, Jerry
The game changer
By George Soros
Published: January 29 2009 02:00 | Last updated: January 29 2009 02:00
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. Lehman was one of the main market-makers in
commercial paper and a large issuer of these short-term obligations
to boot. Reserve Primary, an independent money market fund, held
Lehman paper and, since it had no deep pocket to turn to, it had
to "break the buck" - stop redeeming its shares at par. That caused
panic among depositors: by Thursday a run on money market funds was
in full swing.
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. The claim that they lacked the necessary legal
powers is a lame excuse. In an emergency 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 a deeper level, too, credit default swaps played a critical role
in Lehman's demise. My explanation is controversial and all three
steps of my argument will take the reader to unfamiliar ground.
First, there is an asymmetry in the risk/reward ratio between being
long or short in the stock market. (Being long means owning a stock,
being short means selling a stock one does not own.) Being long has
unlimited potential on the upside but limited exposure on the
downside. Being short is the reverse. The asymmetry manifests itself
in the following way: losing on a long position reduces one's risk
exposure while losing on a short position increases it. As a result,
one can be more patient being long and wrong than being short and
wrong. 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. 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.
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.
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. 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).
The unlimited selling of bonds was facilitated by the CDS market.
Together, the two made a lethal combination.
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.
My argument raises some interesting questions. What would have
happened if the uptick rule on shorting shares had been kept, in
effect, but "naked" short-selling (where the vendor has not borrowed
the stock in advance) 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.
What is the proper role of shortselling? Undoubtedly it gives markets
greater depth and continuity, making them more resilient, but it is
not without dangers. As bear raids can be self-validating, they ought
to be kept under control. If the efficient market hypothesis were
valid, there would be an a priori reason for imposing no constraints.
As it is, both the uptick rule and allowing short-selling only when
it is covered by borrowed stock are useful pragmatic measures that
seem to work well without any clear-cut theoretical justification.
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.
CDS are not, however, the only synthetic financial instruments that
have proved toxic. The same applies to the slicing and dicing of
collateralised debt obligations and to the portfolio insurance
contracts that caused the stock market crash of 1987, to mention only
two that have done a lot of damage. The issuance of stock is closely
regulated by authorities such as the Securities and Exchange
Commission; why not the issuance of derivatives and other synthetic
instruments? The role of reflexivity and the asymmetries identified
earlier ought to prompt a rejection of the efficient market
hypothesis and a thorough reconsideration of the regulatory regime.
Now that the bankruptcy of Lehman has had the same shock effect on
the behaviour of consumers and businesses as the bank failures of the
1930s, the problems facing the administration of President Barack
Obama are even greater than those that confronted Franklin D.
Roosevelt. Total credit outstanding was 160 per cent of gross
domestic product in 1929 and rose to 260 per cent in 1932; we entered
the crash of 2008 at 365 per cent and the ratio is bound to rise to
500 per cent. This is without taking into account the pervasive use
of derivatives, which was absent in the 1930s but immensely
complicates the current situation. On the positive side, we have the
experience of the 1930s and the prescriptions of John Maynard Keynes
to draw on.
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.
If these measures were successful and credit started to expand,
deflationary pressures would be replaced by the spectre of inflation
and the authorities would have to drain the excess money supply from
the economy almost as fast as they had pumped it in. There is no way
to escape from a far-fromequilibrium situation - global deflation and
depression - except by first inducing its opposite and then reducing
it.
To prevent the US economy from sliding into a depression, Mr Obama
must implement a radical and comprehensive set of policies. Alongside
the welladvanced fiscal stimulus package, these should include a
system-wide and compulsory recapitalisation of the banking system and
a thorough overhaul of the mortgage system - reducing the cost of
mortgages and foreclosures.
Energy policy could also play an important role in counteracting both
depression and deflation. The American consumer can no longer act as
the motor of the global economy. Alternative energy and developments
that produce energy savings could serve as a new motor, but only if
the price of conventional fuels is kept high enough to justify
investing in those activities. That would involve putting a floor
under the price of fossil fuels by imposing a price on carbon
emissions and import duties on oil to keep the domestic price above,
say, $70 per barrel.
Finally, the international financial system must be reformed. Far
from providing a level playing field, the current system favours the
countries in control of the international financial institutions,
notably the US, to the detriment of nations at the periphery. The
periphery countries have been subject to the market discipline
dictated by the Washington consensus but the US was exempt from it.
How unfair the system is has been revealed by a crisis that
originated in the US yet is doing more damage to the periphery.
Assistance is needed to protect the financial systems of periphery
countries, including trade finance, something that will require large
contingency funds available at little notice for brief periods of
time. Periphery governments will also need long-term financing to
enable them to engage in counter-cyclical fiscal policies.
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 a condensed, almost shorthand account of what needs to be
done to turn the global economy around. It should give a sense of how
difficult a task it is.
The writer is chairman of Soros Fund Management and founder of the
Open Society Institute. These are extracts from an e-book update to
The New Paradigm for Financial Markets - The credit crisis of 2008
and what it means (Public-Affairs Books, New York)
The Soros investment year
Positions I took were too big for ever more volatile markets
Although I positioned myself reasonably well for what was coming last
year, one thing I got wrong cost me dearly: there was no decoupling
between markets of the developed and developing worlds.
Indian and Chinese stocks were hit even harder than those in the US
and Europe. Since we did not reduce our exposure, we lost more money
in India than we had made the year before. Our Chinese manager did
better by his stock selection; we were also helped by the
appreciation of the renminbi.
I had to push very hard in my macro-account to offset both these
losses and those incurred by our external managers. This had its own
drawback: I overtraded. The positions I took were too large for the
increasingly volatile markets and, in order to manage my risk, I
could not go against the market in a big way. I had to try to catch
minor moves.
That made it difficult to maintain short positions. Although I am an
experienced short-seller, I got caught several times and largely
missed the biggest down-draught, in October and November.
On the long side, where I stuck to my guns, I lost an enormous amount
of money. I was impressed by the potential in the new deep-water
oilfield in Brazil and bought a large strategic position in
Petrobras, only to see it decline by 75 per cent at one point in
time. We also got caught in the developing petrochemical industry in
the Gulf.
We did get out of our strategic long position in CVRD, the Brazilian
iron ore producer, in time for the end of the commodity bubble and
shorted the other big iron ore groups. But we missed an opportunity
in the commodities themselves - partly because I knew from experience
how difficult it is to trade them.
I was also slow to recognise the reversal of fortune for the dollar
and gave back a large portion of our profits. Under the direction of
my new chief investment officer, we did make money in the UK, where
we bet that short-term interest rates would decline and shorted
sterling against the euro. We also made good money by going long on
the credit markets after their collapse.
Eventually I understood that the strength of the dollar was due not
to people choosing to hold dollars but to their inability to maintain
or roll over their dollar obligations. In a very real sense the
strength of the dollar, like the fever associated with sickness, was
a measure of the disruption of the financial system. This insight
helped me to anticipate the downturn of the dollar at the end of
2008. As a result, we ended the year almost meeting my target of 10
per cent minimum return, after spending most of the year in the red.
Copyright The Financial Times Limited 2009
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Received on Thu Jan 29 14:54:05 2009
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