Friday, 6 February 2009Since the 1930's, whenever the world came to the brink of a financial breakdown, the authorities came to the rescue. That is what I expected in 2008, but it did not happen. On September 15, 2008, Lehman Brothers was allowed to collapse. Within days, the entire financial system suffered what amounted to cardiac arrest and had to be put on artificial life support. The effect on the global economy was the equivalent of the breakdown of the banking system during the Great Depression, though the full impact has not yet been felt.
Although the severity of the financial crisis exceeded my expectations I understood early on that we were dealing with something much bigger than a sub-prime mortgage crisis or a housing bubble: we had reached the tipping or reversal point in a process of credit expansion that began after World War II and turned into a super-bubble in the 1980's. Recognizing this point is essential both for understanding where we are now and what policies we should follow.
The Impact of Lehman's Demise
The bankruptcy of Lehman Brothers was a game-changing event. The consequences were disastrous. Credit default swaps (CDS) went through the roof, and AIG, which carried a large short position in them, was facing imminent default. By the next day, United States Treasury Secretary Henry Paulson had to reverse himself and come to AIG's rescue.
But worse was to come. Lehman was one of the main market makers in commercial paper and a major issuer. An independent money-market fund held Lehman paper and, since it had no deep pocket to turn to, had to "break the buck" - stop redeeming its shares at par. This caused panic among depositors, and by September 18 a run on money-market funds was in full swing. The panic spread to the stock market. The Federal Reserve had to extend a guarantee to all money-market funds, short selling of financial stocks was suspended, and the Treasury announced a $700 billion rescue package for the banking system. This provided some temporary relief to the stock market.
But Paulson's $700 billion rescue package was ill conceived or, more correctly, it was not conceived at all. Strangely, the Treasury Secretary was simply not prepared for the consequences of his decision to allow Lehman Brothers to fail. When the financial system collapsed, he rushed to Congress without any clear idea about how he was going to use the money he was requesting. All he had was a rudimentary notion of setting up something like the 1980's-era Resolution Trust Corporation, which acquired and eventually disposed of the assets of failed Savings & Loan institutions.
So Paulson asked for total discretion, including immunity from legal challenge. Unsurprisingly, Congress refused to give it to him. Several voices, my own included, argued that the money would be better spent injecting equity into banks rather than taking toxic assets off their hands. Eventually, Paulson came around to the idea, but he did not execute it properly.
Conditions in the financial system continued to deteriorate. The commercial paper market ground to a close, LIBOR rose, swap rates widened, CDS blew out, and investment banks and other financial institutions without direct access to the Fed could not get overnight or short-term credit. The Fed had to extend one lifeline after another. It was in this atmosphere that the International Monetary Fund held its annual meeting in Washington starting on October 11. The European leaders left early and met the next day in Paris, where they decided to guarantee, in effect, that no major European financial institution would be allowed to fail. But they could not agree to do it on a Europe-wide basis, so each country established its own arrangements. The US quickly followed suit.
These arrangements had an unintended adverse side effect: they brought additional pressure to bear on countries that could not extend similarly credible guarantees to their financial institutions. Iceland was already in a state of collapse. Hungary's largest bank was now subjected to a bear raid, and the currencies and government bond markets of Hungary and the other Eastern European countries fell precipitously. The same happened to Brazil, Mexico, the Asian tigers, and, to a lesser extent, Turkey, South Africa, China, India, Australia,and New Zealand. The euro tanked and the yen soared. The dollar strengthened on a trade-weighted basis. Trade credit in the periphery countries dried up. Volatile currency movements claimed some victims. Leading exporters in Brazil had gotten into the habit of selling options against their appreciating currency and now became insolvent, precipitating a local mini-crash.
Taken together, all these dislocations had a tremendous impact on the behavior and attitudes of consumers, businesses, and financial institutions throughout the world. The financial system had been in crisis since August 2007, but the general public had hardly noticed, and, with some exceptions, business carried on as usual. All this changed in the weeks following September 15, 2008. The global economy sunk like a stone. That became evident as the statistics for October and November began to appear. The wealth effect was enormous. Pension funds, university endowments and charitable institutions lost between 20% and 40% of their assets within a couple of months - and that was before the $50 billion Madoff scandal was exposed. The self-reinforcing recognition that we are facing a deep and long recession, possibly amounting to a depression, became widespread.
Who is to Blame?
The Fed has responded forcefully to the crisis, slashing its main interest rate almost to zero in December, and embarking on quantitative easing. The Obama administration is preparing a two-year fiscal stimulus package in the $800 billion range and other radical measures.
The international response has been more muted. The IMF has approved a new facility that allows periphery countries in sound financial condition to borrow up to five times their quota without conditionality. But the amounts are puny, and the possibility of a stigma continues to linger. As a result, the facility remains unused. The Fed opened swap lines with Mexico, Brazil, Korea and Singapore. But European Central Bank President Jean-Claude Trichet inveighed against fiscal irresponsibility, and Germany remains adamantly opposed to excessive money creation that may lay the groundwork for inflationary pressures in the future. These divergent attitudes render concerted international action extremely difficult to achieve. They may also undermine the unity of the euro and cause wide swings in exchange rates.
In retrospect, the bankruptcy of Lehman Brothers is comparable to the bank failures that occurred in the 1930's. How could it be allowed to occur? The responsibility lies squarely with the financial authorities, notably the Treasury and the Fed, which claim that they lacked the legal authority to intervene. But that is a lame excuse. In an emergency they could, and should, have done whatever was necessary to prevent the system from collapsing, as they have done on other occasions. The fact is, they allowed it to happen. Why?
I would draw a distinction between Paulson and Federal Reserve Chairman Ben Bernanke. Paulson was in charge, because Lehman Brothers, as an investment bank, was not under the Fed's jurisdiction. In my view, Paulson was reluctant to resort to the use of taxpayers' money because he knew that it would entail increased government control. He was a true market fundamentalist. He believed that the same methods and instruments that got the markets into trouble could be used to get them out of it. This led to his abortive plan to create a super-SIV (Special Investment Vehicle) to take over failing SIVs. He subscribed to the doctrine that markets have greater powers to adjust than any individual participant. Coming six months after the Bear Stearns crisis, he must have thought that markets had enough notice to prepare for the failure of Lehman Brothers. That is why he had no Plan B when the markets broke down.
Bernanke was less of an ideologue. Coming from an academic background, the bursting of the super-bubble found him unprepared. He asserted that the housing bubble was an isolated phenomenon that might cause losses of up to $100 billion, which could easily be absorbed. He did not realize that equilibrium theory was fundamentally flawed, so he could not anticipate that the various methods and instruments based on the false assumption that prices deviate from a theoretical equilibrium in a random manner would fail one after another in short order. But he was a fast learner. When he saw what was happening, he responded by drastically lowering interest rates, first in January 2008 and again in December. Unfortunately, his learning process started too late and always lagged behind the course of events. That is how the situation spun out of control.
A Toxic Derivative
On a deeper level the demise of Lehman brothers conclusively falsifies the efficient market hypothesis. My argument is controversial and its three steps 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 shorting of stocks.
Second, the CDS market offers a convenient way of shorting bonds, with the asymmetry in the risk/reward ratio working in the opposite way: shorting bonds by buying a CDS contract carries limited risk but unlimited profit potential, whereas selling CDS contracts offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS's 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. This can be clearly seen in the case of US and United Kingdom government bonds: the actual price of the bonds is much higher than the price implied by CDS's. These asymmetries are difficult to reconcile with the efficient market hypothesis.
Third, reflexivity is at work, which means that 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 so dependent on confidence and trust. That means that bear raids on financial institutions can be self-validating, which directly contradicts the efficient market hypothesis.
Putting these three considerations together leads to the conclusion that Lehman Brothers, AIG, and other financial institutions were destroyed by bear raids in which the shorting of stocks and purchases of CDS's mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule (which would have hindered bear raids by allowing short selling only when prices were rising), while the CDS market facilitated the unlimited selling of bonds. The result was a lethal combination, which 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 brought to the brink of collapse in the short run.
Intriguing Questions
The explanation of the crash of 2008 that I offer raises some important questions.
What would have happened if the uptick rule had been kept in effect and speculating in CDS's outlawed?
The bankruptcy of Lehman Brothers might have been avoided, but what would have happened to the super-bubble? One can only conjecture. My guess is that the super-bubble would have deflated more slowly, with less catastrophic results, but the after-effects would have lingered longer. It would have resembled the Japanese experience more closely than what is happening now.
What is the proper role of short selling?
Undoubtedly, short selling gives markets greater depth and continuity, making them more resilient. But short selling is not without dangers. Bear raids can be self-validating and should 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.
Do credit default swaps serve a useful purpose?
Here, I take a more radical view than most people. The prevailing view is that CDS's should be traded on regulated exchanges. I believe that they are toxic and should be used only by prescription. Their use could be allowed to insure actual bonds, but, in light of their asymmetric character, not to speculate against countries or companies . At this very moment, trading in CDS's is creating trouble for the euro. Several euro-zone countries are becoming over-indebted and face the prospect of ratings downgrades. The purchase of CDS contracts puts additional pressure on their borrowing costs and diminishes the benefit of euro membership, which casts doubts on the common currency's durability. There is an independently existing underlying weakness in the Euro, which is exacerbated by the CDS market in a self-reinforcing fashion .
Credit default swaps are not the only synthetic financial instrument that has proven toxic. The same applies to the slicing and dicing of collateralized debt obligations (CDOs), and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have caused a lot of damage. The issuance of stock is closely regulated by the SEC, why isn't the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries I have identified ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.
Now that the bankruptcy of Lehman Brothers has had the same effect on the behavior of consumers and businesses as the bank failures of the 1930's, the problems facing the incoming Obama administration are even greater than those that confronted President Roosevelt. Total outstanding credit was 160% of GDP in 1929, and rose to 260% in 1932, owing to the accumulation of debt and the decline of GDP. We entered into the Crash of 2008 with outstanding credit at 365% of GDP, which is bound to rise to 500% And this calculation does not take into account the pervasive use of derivatives, which were absent in the 1930's but complicate the current situation immensely, particularly in the housing market. On the positive side, we have the experience of the 1930's and the prescriptions of John Maynard Keynes to draw on.
With this in mind, I will next outline the policies that in my opinion the Obama administration ought to pursue, and then assess how the future may play out.
George Soros is Chairman of Soros Fund Management. His latest book is Reflections on the Crash of 2008.
Copyright: Project Syndicate, 2009.
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Friday, 6 February 2009
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