[Pen-l] Soros: Obama must implement a radical and comprehensive set of policies

[Louis Proyect <lnp3@xxxxxxxxx>]

http://www.ft.com/cms/s/0/49b1654a-ed60-11dd-bd60-0000779fd2ac.html
Financial Times, Jan. 29, 2009
The game changer
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. 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)


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