A thick stew of financial analysis
Whether you like the policy prescriptions of George Soros or you abhor them, his analysis of the causes and the terrible consequences of the Lehman failure is fascinating reading. FT:
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…
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…
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.
Soros has some policy recommendations that appear off-base, like artificially raising the price of oil, and his analysis of CDS’s versus US and UK government bonds (not in the excerpt above) seems to have potentially sinister implications, but his comparison of Lehman to the folly that started the Great Depression appears to us to be largely correct. It is the hole that the government has been trying frantically to get out of for the last four months.
January 30th, 2009 at 2:29 am
We didn’t have as many women working back then, so they could go to work and be harvested for taxes. Now source is tapped out. (Let’s say we’ve reached Peak Tax )
We didn’t have the high rates of home mortgage debt then as now. So now even more people will lose their houses for debts and taxes.
We didn’t have the high rates of local, state and federal taxes.
We didn’t have pensions, Social Security, Medicaid and Medicare costs
We didn’t have as many lawyers, NIMYBY’s, rules, regulations, permits, fees and hearings so that now any economic project takes years of lawyers and hearings.
We had many young people, we don’t now.
Many were still on the farm or not too far from self sufficiency’s. Not anymore.
You could patch your Model T, try that on your Honda.
We didn’t have entire urban core of drugs, crimes and illiteracy.
We weren’t in debt to China and looking to them for work ethic, high quality manufacturing and even our food.
Other than that everything is looking great.
January 30th, 2009 at 4:23 am
It seems to me that Soros may have some points about the tactics that took down the system, but fails to explain why they worked so well. In retrospect, it’s not that hard to understand, though I haven’t seen it explained this way anywhere:
The consumer debt structure of the U.S., and indeed the world, financial system was built on a foundation of Fannie- and Freddie-backed collateralized debt obligations. These notes were considered “safe”, largely because they had an “implicit” government guarantee in case anything went wrong. Many Congress-critters explicitly encouraged this view, including Chris Dodd and Barney Frank. This led financial houses to take on tremendous leverage with these “safe” investments as capital.
When Lehman got into trouble based on non-payment of the loans these CDOs were based on, it was put up or shut up time for the Feds. But they made the choice not only to default on their “implicit” guarantee, but to actively destroy Lehman for the mistake of having trusted the Feds.
The result should have been obvious.
January 30th, 2009 at 7:32 am
Soros says the Government erred in letting Lehman go belly up. Let’s assume he his right. Things like this will happen when you have Government managing the crash. Mistakes will be made. Bureaucrats are people and no one makes the right choice every time.
January 30th, 2009 at 3:26 pm
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.
And never mind that stupid Constitution of yours; it’s just a piece of paper.
That sounds like him.