Tuesday, October 28, 2008

George Soros on the superbubble, the bailout and Paulson & Co.

Update: 3/12/09

MIT posted a video of this talk awhile back. So while I took decent notes, if you have an hour you can watch the talk here. Actually, most of the interesting points came in the first hour.

George Soros talked bubble and bailout today at his talk at MIT. Here’s are some of the quotes and a summary of some of the most interesting point.

“The future is determined by the decisions people make, and since people don’t make their decision on rational decisions or predictable theories. For instance, the way Henry Paulson and his team responded to Lehman Brothers changed the course of history.” said Soros. Soros was emphatic that allowing Lehman to default was a mistake. Effectively, that was the point that led to the financial system melting down.

Soros was highly critical of Paulson on other fronts and says that Paulson has not taken the necessary steps. The necessary steps would have been:

1) Re-start lending by recapitalizing the banks. Paulson has moved over on this – Soros had suggested to him that injecting equity was more important than taking debt. Soros said that his idea was inject equity in the form of a convertible bond at a low rate as to not impair operations. This could have been covered by the markets, or if not, by the treasury. In either case, the treasury would serve as an underwriter.

2) Prevent the housing crisis from overshooting on the downside by reducing foreclosures to a minimum. Soros believes the solution has to involve shaving the mortgages down to the level of the value of the homes. “You have to downsize the mortgages to 80% of the current home values, so that even if there is a further drop people have positive equity.” Soros says this is hard – changing a contract post agreement is unconstitutional, but it somehow must be done. Addendum: Greg Mankiw has some analysis on a couple suggestions on how to do this.

3) Stabilize the global economy: Allow more nations with sound economies to run fiscal deficits to keep their economies running. (Editor’s note: I’m not aware of restrictions, but there may be some in place from the IMF).

Soros contended that the housing bubble was like a small bubble, a detonator that set off a superbubble that has been brewing for 25 years created by the increasing use of leverage, and that markets are efficient. This resulted in deregulation and the increasing use of financial instruments. Regulators themselves believed that markets were self-regulating. In his book released earlier this year, The New Paradigm for Financial Markets, he described the superbubble had built up and predicted that it would collapse. I don’t need to tell you whether that came true or not. Said Soros, “With bubbles, reality actually confirms the truth and misconception, until the difference is so great it is not sustainable. It’s a non-linear process that is initially self-reinforcing and in the end self-defeating.”

Soros believes that as a working hypothesis, most of the time people assume markets are right. It’s more instructive to think of the markets as always wrong.

“Usually, markets correct their own mistakes, so these things are not that common. Occasionally you have this type of self-reinforcing situation. This is usually driven by a trend: for example, Internet, or increasing usage of leverage. Then, there is a misinterpretation and sets off this reinforcing process. In this case, it was that the price of real estate is independent of the ability to lend.” We've obviously learned those are intrinsically linked.

Soros shared a conversation he had with Alan Greenspan in the past. Greenspan said that financial innovation brings such great benefits that it outweighs the cost of the occasional bubble. Soros says that until this period, Greenspan had a real argument, but now the flaws in the system have become self-defeating.

Soros argues that this crisis is self-generated by the system and it originated at the center (the core developed nations, especially the US and UK). It is not due to an external shock as some claim. The natural thing to do, says Soros, is to focus on saving the center (that being the US, UK, etc.) and not the nations on the periphery that are suffering, such as Iceland and the Ukraine. Countries at the periphery have historically been subject to discipline while powerful nations focus on saving the core of the system. 1982 was the first example of this, where the Central banks saved the system, but sent Mexico through the wringer.

Soros said the US must successfully lead an effort to stabilize the system (although he doesn’t think the Bush administration can do it), including peripheral nations and banking systems in order to remain at the center. Soros says to this point, “Otherwise, the system as we know will not continue. A new system will emerge and the US will not have the type of influence it has now.”


Agent Zero said...

Wow...tough on Paulson.

Ned said...

"Regulators themselves believed that markets were self-regulating."

“Usually, markets correct their own mistakes, so these things are not that common."

He seems to be blaming regulators for believing in efficient markets, when he also believes they are efficient.

Ted Chan said...

Yeah, the implication during the talk was that regulators need to be able to identify those exceptions when the markets are not behaving rationally. For example, the disaggregation of risk between mortgages and MBS should be something that regulators should have picked up on. This is a relatively easy perspective to have in retrospect.