Monday, August 16, 2010
Berkshire Hathaway & Buffett’s Latest Stock Holdings
http://247wallst.com/2010/08/16/berkshire-hathaway-buffetts-latest-stock-holdings-h-to-r-brk-b-hog-hd-ir-irm-jnj-kft-low-mco-nrg-nlc-nke-pg-pg-rsg/
The Crisis & What to Do About It
The Crisis & What to Do About It
By George Soros
1.
The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. To understand what has happened, and what should be done to avoid such a catastrophic crisis in the future, will require a new way of thinking about how markets work.
Consider how the crisis has unfolded over the past eighteen months. The proximate cause is to be found in the housing bubble or more exactly in the excesses of the subprime mortgage market. The longer a double-digit rise in house prices lasted, the more lax the lending practices became. In the end, people could borrow 100 percent of inflated house prices with no money down. Insiders referred to subprime loans as ninja loans—no income, no job, no questions asked.
The excesses became evident after house prices peaked in 2006 and subprime mortgage lenders began declaring bankruptcy around March 2007. The problems reached crisis proportions in August 2007. The Federal Reserve and other financial authorities had believed that the subprime crisis was an isolated phenomenon that might cause losses of around $100 billion. Instead, the crisis spread with amazing rapidity to other markets. Some highly leveraged hedge funds collapsed and some lightly regulated financial institutions, notably the largest mortgage originator in the US, Countrywide Financial, had to be acquired by other institutions in order to survive.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Confidence in the creditworthiness of many financial institutions was shaken and interbank lending was disrupted. In quick succession, a variety of esoteric credit markets—ranging from collateralized debt obligations (CDOs) to auction-rated municipal bonds—broke down one after another. After periods of relative calm and partial recovery, crisis episodes recurred in January 2008, precipitated by a rogue trader at Société Générale; in March, associated with the demise of Bear Stearns; and then in July, when IndyMac Bank, the largest savings bank in the Los Angeles area, went into receivership, becoming the fourth-largest bank failure in US history. The deepest fall of all came in September, caused by the disorderly bankruptcy of Lehman Brothers in which holders of commercial paper—for example, short-term, unsecured promissory notes—issued by Lehman lost their money.
Then the inconceivable occurred: the financial system actually melted down. A large money market fund that had invested in commercial paper issued by Lehman Brothers "broke the buck," i.e., its asset value fell below the dollar amount deposited, breaking an implicit promise that deposits in such funds are totally safe and liquid. This started a run on money market funds and the funds stopped buying commercial paper. Since they were the largest buyers, the commercial paper market ceased to function. The issuers of commercial paper were forced to draw down their credit lines, bringing interbank lending to a standstill. Credit spreads—i.e., the risk premium over and above the riskless rate of interest—widened to unprecedented levels and eventually the stock market was also overwhelmed by panic. All this happened in the space of a week.
With the financial system in cardiac arrest, resuscitating it took precedence over considerations of moral hazard—i.e., the danger that coming to the rescue of a financial institution in difficulties would reward and encourage reckless behavior in the future—and the authorities injected ever larger quantities of money. The balance sheet of the Federal Reserve ballooned from $800 billion to $1,800 billion in a couple of weeks. When that was not enough, the American and European financial authorities committed themselves not to allow any other major financial institution to fail.
These unprecedented measures have begun to have an effect: interbank lending has resumed and the London Interbank Offered Rate (LIBOR) has improved. The financial crisis has shown signs of abating. But guaranteeing that the banks at the center of the global financial system will not fail has precipitated a new crisis that caught the authorities unawares: countries at the periphery, whether in Eastern Europe, Asia, or Latin America, could not offer similarly credible guarantees, and financial capital started fleeing from the periphery to the center. All currencies fell against the dollar and the yen, some of them precipitously. Commodity prices dropped like a stone and interest rates in emerging markets soared. So did premiums on insurance against credit default. Hedge funds and other leveraged investors suffered enormous losses, precipitating margin calls and forced selling that have also spread to markets at the center.
Unfortunately the authorities are always lagging behind events. The International Monetary Fund is establishing a new credit facility that allows financially sound periphery countries to borrow without any conditions up to five times their annual quota, but that is too little too late. A much larger pool of money is needed to reassure markets. And if the top tier of periphery countries is saved, what happens to the lower-tier countries? The race to save the international financial system is still ongoing. Even if it is successful, consumers, investors, and businesses are undergoing a traumatic experience whose full impact on global economic activity is yet to be felt. A deep recession is now inevitable and the possibility of a depression cannot be ruled out. When I predicted earlier this year that we were facing the worst financial crisis since the 1930s, I did not anticipate that conditions would deteriorate so badly.
2.
This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.
While the two-way connection is present at all times, it is only occasionally, and in special circumstances, that it gives rise to financial crises. Usually markets correct their own mistakes, but occasionally there is a misconception or misinterpretation that finds a way to reinforce a trend that is already present in reality and by doing so it also reinforces itself. Such self- reinforcing processes may carry markets into far-from-equilibrium territory. Unless something happens to abort the reflexive interaction sooner, it may persist until the misconception becomes so glaring that it has to be recognized as such. When that happens the trend becomes unsustainable and when it is reversed the self-reinforcing process starts working in the opposite direction, causing a sharp downward movement.
The typical sequence of boom and bust has an asymmetric shape. The boom develops slowly and accelerates gradually. The bust, when it occurs, tends to be short and sharp. The asymmetry is due to the role that credit plays. As prices rise, the same collateral can support a greater amount of credit. Rising prices also tend to generate optimism and encourage a greater use of leverage—borrowing for investment purposes. At the peak of the boom both the value of the collateral and the degree of leverage reach a peak. When the price trend is reversed participants are vulnerable to margin calls and, as we've seen in 2008, the forced liquidation of collateral leads to a catastrophic acceleration on the downside.
Bubbles thus have two components: a trend that prevails in reality and a misconception relating to that trend. The simplest and most common example is to be found in real estate. The trend consists of an increased willingness to lend and a rise in prices. The misconception is that the value of the real estate is independent of the willingness to lend. That misconception encourages bankers to become more lax in their lending practices as prices rise and defaults on mortgage payments diminish. That is how real estate bubbles, including the recent housing bubble, are born. It is remarkable how the misconception continues to recur in various guises in spite of a long history of real estate bubbles bursting.
Bubbles are not the only manifestations of reflexivity in financial markets, but they are the most spectacular. Bubbles always involve the expansion and contraction of credit and they tend to have catastrophic consequences. Since financial markets are prone to produce bubbles and bubbles cause trouble, financial markets have become regulated by the financial authorities. In the United States they include the Federal Reserve, the Treasury, the Securities and Exchange Commission, and many other agencies.
It is important to recognize that regulators base their decisions on a distorted view of reality just as much as market participants—perhaps even more so because regulators are not only human but also bureaucratic and subject to political influences. So the interplay between regulators and market participants is also reflexive in character. In contrast to bubbles, which occur only infrequently, the cat-and-mouse game between regulators and markets goes on continuously. As a consequence reflexivity is at work at all times and it is a mistake to ignore its influence. Yet that is exactly what the prevailing theory of financial markets has done and that mistake is ultimately responsible for the severity of the current crisis.
3.
In my book The New Paradigm for Financial Markets,[*] I argue that the current crisis differs from the various financial crises that preceded it. I base that assertion on the hypothesis that the explosion of the US housing bubble acted as the detonator for a much larger "super-bubble" that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit—whether extended to consumers or speculators or banks—has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom.
The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect.
Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.
Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences. Indeed, we have experienced a series of financial crises since then, but the adverse consequences were suffered principally by the countries that lie on the periphery of the global financial system, not by those at the center. The system is under the control of the developed countries, especially the United States, which enjoys veto rights in the International Monetary Fund.
Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices.
It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006. Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. They ought to have known better since it was their actions that kept the United States economy on an even keel. Alan Greenspan, in particular, believed that giving users of financial innovations such as derivatives free rein brought such great benefits that having to clean up behind the occasional financial mishap was a small price to pay. And his analysis of the costs and benefits of his permissive policies was not totally wrong while the super-bubble lasted. Only now has he been forced to acknowledge that there was a flaw in his argument.
Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and "managing" risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion. But the increased use of financial engineering set in motion a process of boom and bust. So eventually there was hell to pay. At first the occasional financial crises served as successful tests. But the subprime crisis came to play a different role: it served as the culmination or reversal point of the super-bubble.
It should be emphasized that this interpretation of the current situation does not necessarily follow from my model of boom and bust. Had the financial authorities succeeded in containing the subprime crisis—as they thought at the time they would be able to do—this would have been seen as just another successful test instead of the reversal point. I have cried wolf three times: first with The Alchemy of Finance in 1987, then with The Crisis of Global Capitalism in 1998, and now. Only now did the wolf arrive.
My interpretation of financial markets based on reflexivity can explain events better than it can predict them. It is less ambitious than the previous theory. It does not claim to determine the outcome as equilibrium theory does. It can assert that a boom must eventually lead to a bust, but it cannot determine either the extent or the duration of a boom. Indeed, those of us who recognized that there was a housing bubble expected it to burst much sooner. Had it done so, the damage would have been much smaller and the super-bubble may have remained intact. Most of the damage was caused by mortgage-related securities issued in the last two years of the housing boom.
The fact that the new paradigm does not claim to predict the future explains why it did not make any headway until now, but in the light of recent experience it can no longer be ignored. We must come to terms with the fact that reflexivity introduces an element of uncertainty into financial markets that the previous theory left out of account. That theory was used to establish mathematical models for calculating risk and converting bundles of subprime mortgages into tradable securities, as well as other forms of debt. Uncertainty by definition cannot be quantified. Excessive reliance on those mathematical models did untold harm.
4.
The new paradigm has far-reaching implications for the regulation of financial markets. Since they are prone to create asset bubbles, regulators such as the Fed, the Treasury, and the SEC must accept responsibility for preventing bubbles from growing too big. Until now financial authorities have explicitly rejected that responsibility.
It is impossible to prevent bubbles from forming, but it should be possible to keep them within tolerable bounds. It cannot be done by controlling only the money supply. Regulators must also take into account credit conditions because money and credit do not move in lockstep. Markets have moods and biases and it falls to regulators to counterbalance them. That requires the use of judgment and since regulators are also human, they are bound to make mistakes. They have the advantage, however, of getting feedback from the market and that should enable them to correct their mistakes. If a tightening of margin and minimum capital requirements does not deflate a bubble, they can tighten them some more. But the process is not foolproof because markets can also be wrong. The search for the optimum equilibrium has to be a never-ending process of trial and error.
The cat-and-mouse game between regulators and market participants is already ongoing, but its true nature has not yet been acknowledged. Alan Greenspan was a past master of manipulation with his Delphic utterances, but instead of acknowledging what he was doing he pretended that he was merely a passive observer of the facts. Reflexivity remained a state secret. That is why the super-bubble could develop so far during his tenure.
Since money and credit do not move in lockstep and asset bubbles cannot be controlled purely by monetary means, additional tools must be employed, or more accurately reactivated, since they were in active use in the 1950s and 1960s. I refer to variable margin requirements and minimal capital requirements, which are meant to control the amount of leverage market participants can employ. Central banks even used to issue guidance to banks about how they should allocate loans to specific sectors of the economy. Such directives may be preferable to the blunt instruments of monetary policy in combating "irrational exuberance" in particular sectors, such as information technology or real estate.
Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used. Such regulation should be a high priority of the new Obama administration. It is all the more necessary because financial engineering often aims at circumventing regulations.
Take for example credit default swaps (CDSs), instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.
Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.
In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.
—November 6, 2008
By George Soros
1.
The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. To understand what has happened, and what should be done to avoid such a catastrophic crisis in the future, will require a new way of thinking about how markets work.
Consider how the crisis has unfolded over the past eighteen months. The proximate cause is to be found in the housing bubble or more exactly in the excesses of the subprime mortgage market. The longer a double-digit rise in house prices lasted, the more lax the lending practices became. In the end, people could borrow 100 percent of inflated house prices with no money down. Insiders referred to subprime loans as ninja loans—no income, no job, no questions asked.
The excesses became evident after house prices peaked in 2006 and subprime mortgage lenders began declaring bankruptcy around March 2007. The problems reached crisis proportions in August 2007. The Federal Reserve and other financial authorities had believed that the subprime crisis was an isolated phenomenon that might cause losses of around $100 billion. Instead, the crisis spread with amazing rapidity to other markets. Some highly leveraged hedge funds collapsed and some lightly regulated financial institutions, notably the largest mortgage originator in the US, Countrywide Financial, had to be acquired by other institutions in order to survive.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Confidence in the creditworthiness of many financial institutions was shaken and interbank lending was disrupted. In quick succession, a variety of esoteric credit markets—ranging from collateralized debt obligations (CDOs) to auction-rated municipal bonds—broke down one after another. After periods of relative calm and partial recovery, crisis episodes recurred in January 2008, precipitated by a rogue trader at Société Générale; in March, associated with the demise of Bear Stearns; and then in July, when IndyMac Bank, the largest savings bank in the Los Angeles area, went into receivership, becoming the fourth-largest bank failure in US history. The deepest fall of all came in September, caused by the disorderly bankruptcy of Lehman Brothers in which holders of commercial paper—for example, short-term, unsecured promissory notes—issued by Lehman lost their money.
Then the inconceivable occurred: the financial system actually melted down. A large money market fund that had invested in commercial paper issued by Lehman Brothers "broke the buck," i.e., its asset value fell below the dollar amount deposited, breaking an implicit promise that deposits in such funds are totally safe and liquid. This started a run on money market funds and the funds stopped buying commercial paper. Since they were the largest buyers, the commercial paper market ceased to function. The issuers of commercial paper were forced to draw down their credit lines, bringing interbank lending to a standstill. Credit spreads—i.e., the risk premium over and above the riskless rate of interest—widened to unprecedented levels and eventually the stock market was also overwhelmed by panic. All this happened in the space of a week.
With the financial system in cardiac arrest, resuscitating it took precedence over considerations of moral hazard—i.e., the danger that coming to the rescue of a financial institution in difficulties would reward and encourage reckless behavior in the future—and the authorities injected ever larger quantities of money. The balance sheet of the Federal Reserve ballooned from $800 billion to $1,800 billion in a couple of weeks. When that was not enough, the American and European financial authorities committed themselves not to allow any other major financial institution to fail.
These unprecedented measures have begun to have an effect: interbank lending has resumed and the London Interbank Offered Rate (LIBOR) has improved. The financial crisis has shown signs of abating. But guaranteeing that the banks at the center of the global financial system will not fail has precipitated a new crisis that caught the authorities unawares: countries at the periphery, whether in Eastern Europe, Asia, or Latin America, could not offer similarly credible guarantees, and financial capital started fleeing from the periphery to the center. All currencies fell against the dollar and the yen, some of them precipitously. Commodity prices dropped like a stone and interest rates in emerging markets soared. So did premiums on insurance against credit default. Hedge funds and other leveraged investors suffered enormous losses, precipitating margin calls and forced selling that have also spread to markets at the center.
Unfortunately the authorities are always lagging behind events. The International Monetary Fund is establishing a new credit facility that allows financially sound periphery countries to borrow without any conditions up to five times their annual quota, but that is too little too late. A much larger pool of money is needed to reassure markets. And if the top tier of periphery countries is saved, what happens to the lower-tier countries? The race to save the international financial system is still ongoing. Even if it is successful, consumers, investors, and businesses are undergoing a traumatic experience whose full impact on global economic activity is yet to be felt. A deep recession is now inevitable and the possibility of a depression cannot be ruled out. When I predicted earlier this year that we were facing the worst financial crisis since the 1930s, I did not anticipate that conditions would deteriorate so badly.
2.
This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.
While the two-way connection is present at all times, it is only occasionally, and in special circumstances, that it gives rise to financial crises. Usually markets correct their own mistakes, but occasionally there is a misconception or misinterpretation that finds a way to reinforce a trend that is already present in reality and by doing so it also reinforces itself. Such self- reinforcing processes may carry markets into far-from-equilibrium territory. Unless something happens to abort the reflexive interaction sooner, it may persist until the misconception becomes so glaring that it has to be recognized as such. When that happens the trend becomes unsustainable and when it is reversed the self-reinforcing process starts working in the opposite direction, causing a sharp downward movement.
The typical sequence of boom and bust has an asymmetric shape. The boom develops slowly and accelerates gradually. The bust, when it occurs, tends to be short and sharp. The asymmetry is due to the role that credit plays. As prices rise, the same collateral can support a greater amount of credit. Rising prices also tend to generate optimism and encourage a greater use of leverage—borrowing for investment purposes. At the peak of the boom both the value of the collateral and the degree of leverage reach a peak. When the price trend is reversed participants are vulnerable to margin calls and, as we've seen in 2008, the forced liquidation of collateral leads to a catastrophic acceleration on the downside.
Bubbles thus have two components: a trend that prevails in reality and a misconception relating to that trend. The simplest and most common example is to be found in real estate. The trend consists of an increased willingness to lend and a rise in prices. The misconception is that the value of the real estate is independent of the willingness to lend. That misconception encourages bankers to become more lax in their lending practices as prices rise and defaults on mortgage payments diminish. That is how real estate bubbles, including the recent housing bubble, are born. It is remarkable how the misconception continues to recur in various guises in spite of a long history of real estate bubbles bursting.
Bubbles are not the only manifestations of reflexivity in financial markets, but they are the most spectacular. Bubbles always involve the expansion and contraction of credit and they tend to have catastrophic consequences. Since financial markets are prone to produce bubbles and bubbles cause trouble, financial markets have become regulated by the financial authorities. In the United States they include the Federal Reserve, the Treasury, the Securities and Exchange Commission, and many other agencies.
It is important to recognize that regulators base their decisions on a distorted view of reality just as much as market participants—perhaps even more so because regulators are not only human but also bureaucratic and subject to political influences. So the interplay between regulators and market participants is also reflexive in character. In contrast to bubbles, which occur only infrequently, the cat-and-mouse game between regulators and markets goes on continuously. As a consequence reflexivity is at work at all times and it is a mistake to ignore its influence. Yet that is exactly what the prevailing theory of financial markets has done and that mistake is ultimately responsible for the severity of the current crisis.
3.
In my book The New Paradigm for Financial Markets,[*] I argue that the current crisis differs from the various financial crises that preceded it. I base that assertion on the hypothesis that the explosion of the US housing bubble acted as the detonator for a much larger "super-bubble" that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit—whether extended to consumers or speculators or banks—has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom.
The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect.
Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.
Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences. Indeed, we have experienced a series of financial crises since then, but the adverse consequences were suffered principally by the countries that lie on the periphery of the global financial system, not by those at the center. The system is under the control of the developed countries, especially the United States, which enjoys veto rights in the International Monetary Fund.
Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices.
It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006. Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. They ought to have known better since it was their actions that kept the United States economy on an even keel. Alan Greenspan, in particular, believed that giving users of financial innovations such as derivatives free rein brought such great benefits that having to clean up behind the occasional financial mishap was a small price to pay. And his analysis of the costs and benefits of his permissive policies was not totally wrong while the super-bubble lasted. Only now has he been forced to acknowledge that there was a flaw in his argument.
Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and "managing" risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion. But the increased use of financial engineering set in motion a process of boom and bust. So eventually there was hell to pay. At first the occasional financial crises served as successful tests. But the subprime crisis came to play a different role: it served as the culmination or reversal point of the super-bubble.
It should be emphasized that this interpretation of the current situation does not necessarily follow from my model of boom and bust. Had the financial authorities succeeded in containing the subprime crisis—as they thought at the time they would be able to do—this would have been seen as just another successful test instead of the reversal point. I have cried wolf three times: first with The Alchemy of Finance in 1987, then with The Crisis of Global Capitalism in 1998, and now. Only now did the wolf arrive.
My interpretation of financial markets based on reflexivity can explain events better than it can predict them. It is less ambitious than the previous theory. It does not claim to determine the outcome as equilibrium theory does. It can assert that a boom must eventually lead to a bust, but it cannot determine either the extent or the duration of a boom. Indeed, those of us who recognized that there was a housing bubble expected it to burst much sooner. Had it done so, the damage would have been much smaller and the super-bubble may have remained intact. Most of the damage was caused by mortgage-related securities issued in the last two years of the housing boom.
The fact that the new paradigm does not claim to predict the future explains why it did not make any headway until now, but in the light of recent experience it can no longer be ignored. We must come to terms with the fact that reflexivity introduces an element of uncertainty into financial markets that the previous theory left out of account. That theory was used to establish mathematical models for calculating risk and converting bundles of subprime mortgages into tradable securities, as well as other forms of debt. Uncertainty by definition cannot be quantified. Excessive reliance on those mathematical models did untold harm.
4.
The new paradigm has far-reaching implications for the regulation of financial markets. Since they are prone to create asset bubbles, regulators such as the Fed, the Treasury, and the SEC must accept responsibility for preventing bubbles from growing too big. Until now financial authorities have explicitly rejected that responsibility.
It is impossible to prevent bubbles from forming, but it should be possible to keep them within tolerable bounds. It cannot be done by controlling only the money supply. Regulators must also take into account credit conditions because money and credit do not move in lockstep. Markets have moods and biases and it falls to regulators to counterbalance them. That requires the use of judgment and since regulators are also human, they are bound to make mistakes. They have the advantage, however, of getting feedback from the market and that should enable them to correct their mistakes. If a tightening of margin and minimum capital requirements does not deflate a bubble, they can tighten them some more. But the process is not foolproof because markets can also be wrong. The search for the optimum equilibrium has to be a never-ending process of trial and error.
The cat-and-mouse game between regulators and market participants is already ongoing, but its true nature has not yet been acknowledged. Alan Greenspan was a past master of manipulation with his Delphic utterances, but instead of acknowledging what he was doing he pretended that he was merely a passive observer of the facts. Reflexivity remained a state secret. That is why the super-bubble could develop so far during his tenure.
Since money and credit do not move in lockstep and asset bubbles cannot be controlled purely by monetary means, additional tools must be employed, or more accurately reactivated, since they were in active use in the 1950s and 1960s. I refer to variable margin requirements and minimal capital requirements, which are meant to control the amount of leverage market participants can employ. Central banks even used to issue guidance to banks about how they should allocate loans to specific sectors of the economy. Such directives may be preferable to the blunt instruments of monetary policy in combating "irrational exuberance" in particular sectors, such as information technology or real estate.
Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used. Such regulation should be a high priority of the new Obama administration. It is all the more necessary because financial engineering often aims at circumventing regulations.
Take for example credit default swaps (CDSs), instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.
Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.
In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.
—November 6, 2008
Friday, August 13, 2010
News Blitz 13 Aug 2010
What an exciting ride... to see the roller coaster ride of Genting!
News Blitz
Genting S'pore gets a billion reasons to smile
Q2 revenue rockets and profit hits S$397m as RWS churns out the cash
Fed resorting to tools Japan used in past decade
Quantitative easing - credit easing to Fed - failed to spur lending in Japan
(WASHINGTON) The Federal Reserve's decision to sustain the current level of its assets intensifies the focus of the central bank on policy tools similar to those used with little impact by Japan last decade.
July growth in Australian employment slows
(SYDNEY) Australian employment growth slowed in July, driving down the nation's currency as investors bet that the central bank would extend a pause in the most aggressive round of interest-rate increases by a member-nation of Group of 20.
Japan manuf mood at near 3-yr high: Reuters Tankan
TOKYO - Japanese manufacturers' confidence rose to the highest in nearly three years in August due to government stimulus, but companies forecast for the first time in three years that their sentiment will deteriorate as the strong yen threatens exporters' earnings, a Reuters poll showed.
China 'will not halt property tightening'
BEIJING - China will not relax its policies aimed at curbing speculation in the property market, Vice-Premier Li Keqiang said on Friday, according to state radio.
On an inspection of low-income housing in Beijing, Mr Li also reiterated that the government would step up its efforts to build more affordable housing.
Preparing for deflation
After worrying about inflation for months, many economists are now talking about deflation in the US. What should investors do to hedge against such a scenario?
Go for blue chips
Investors who want to maintain their stock weightings should consider 'high-quality, large, blue-chip companies that have balance-sheet strength', said Brian McMahon, chief investment officer at Thornburg Investment Management in Santa Fe, New Mexico. He said companies like Google and Microsoft often have an added advantage: dominance over their industries, enabling them to maintain their prices even if others in the industry start to lower theirs.
Stocks that pay dividends would also make sense, because the cash thrown off by these shares would be quite valuable in a deflationary environment.
In fact, said Mr Inker of GMO, if investors really fear deflation, they might consider increasing the cash in their portfolios. 'There's a strong case for building up dry powder,' he said. 'If something bad happens economically - whether it's deflation or inflation - that generally provides a good buying opportunity for investors who have some cash to put to work.' - NYT
US consumer prices rise 0.3% in July
WASHINGTON - Higher energy costs helped lift US consumer prices in July, the first rise in four months, according to a government report on Friday that could ease concerns about deflation.
US retail sales rebound in July, softness lingers
WASHINGTON - US retail sales rose in July in a hopeful sign for the economy, but the gains were concentrated in auto and petrol station sales, suggesting underlying momentum in consumer spending remains tame.
Sales climbed 0.4 per cent last month following a revised 0.3 per cent drop in June, the Commerce Department said on Friday. Economists polled by Reuters had been looking for a slightly firmer 0.5 per cent gain.
Germany posts record second quarter growth
FRANKFURT - A global economic recovery pushed German quarterly growth to a record 2.2 per cent in the second quarter of the year, data released Friday by the national statistics office showed.
Others
August 9, 2010, 12.18 pm (Singapore time)
China extends Japanese debt buying spree in June
TOKYO - China extended a record buying spree of Japanese debt in June as sovereign debt concerns buffeted the euro, purchasing a net US$5.9 billion of short-term bills although it was a net seller of longer dated notes.
News Blitz
Genting S'pore gets a billion reasons to smile
Q2 revenue rockets and profit hits S$397m as RWS churns out the cash
Fed resorting to tools Japan used in past decade
Quantitative easing - credit easing to Fed - failed to spur lending in Japan
(WASHINGTON) The Federal Reserve's decision to sustain the current level of its assets intensifies the focus of the central bank on policy tools similar to those used with little impact by Japan last decade.
July growth in Australian employment slows
(SYDNEY) Australian employment growth slowed in July, driving down the nation's currency as investors bet that the central bank would extend a pause in the most aggressive round of interest-rate increases by a member-nation of Group of 20.
Japan manuf mood at near 3-yr high: Reuters Tankan
TOKYO - Japanese manufacturers' confidence rose to the highest in nearly three years in August due to government stimulus, but companies forecast for the first time in three years that their sentiment will deteriorate as the strong yen threatens exporters' earnings, a Reuters poll showed.
China 'will not halt property tightening'
BEIJING - China will not relax its policies aimed at curbing speculation in the property market, Vice-Premier Li Keqiang said on Friday, according to state radio.
On an inspection of low-income housing in Beijing, Mr Li also reiterated that the government would step up its efforts to build more affordable housing.
Preparing for deflation
After worrying about inflation for months, many economists are now talking about deflation in the US. What should investors do to hedge against such a scenario?
Go for blue chips
Investors who want to maintain their stock weightings should consider 'high-quality, large, blue-chip companies that have balance-sheet strength', said Brian McMahon, chief investment officer at Thornburg Investment Management in Santa Fe, New Mexico. He said companies like Google and Microsoft often have an added advantage: dominance over their industries, enabling them to maintain their prices even if others in the industry start to lower theirs.
Stocks that pay dividends would also make sense, because the cash thrown off by these shares would be quite valuable in a deflationary environment.
In fact, said Mr Inker of GMO, if investors really fear deflation, they might consider increasing the cash in their portfolios. 'There's a strong case for building up dry powder,' he said. 'If something bad happens economically - whether it's deflation or inflation - that generally provides a good buying opportunity for investors who have some cash to put to work.' - NYT
US consumer prices rise 0.3% in July
WASHINGTON - Higher energy costs helped lift US consumer prices in July, the first rise in four months, according to a government report on Friday that could ease concerns about deflation.
US retail sales rebound in July, softness lingers
WASHINGTON - US retail sales rose in July in a hopeful sign for the economy, but the gains were concentrated in auto and petrol station sales, suggesting underlying momentum in consumer spending remains tame.
Sales climbed 0.4 per cent last month following a revised 0.3 per cent drop in June, the Commerce Department said on Friday. Economists polled by Reuters had been looking for a slightly firmer 0.5 per cent gain.
Germany posts record second quarter growth
FRANKFURT - A global economic recovery pushed German quarterly growth to a record 2.2 per cent in the second quarter of the year, data released Friday by the national statistics office showed.
Others
August 9, 2010, 12.18 pm (Singapore time)
China extends Japanese debt buying spree in June
TOKYO - China extended a record buying spree of Japanese debt in June as sovereign debt concerns buffeted the euro, purchasing a net US$5.9 billion of short-term bills although it was a net seller of longer dated notes.
Wednesday, August 4, 2010
Food for thought on 4 Aug 2010
August 2, 2010
Earnings Season: Worry About Next Year, The Second Quarter Is History
I think some of it is expectation management as you put it out, but remember what the comparisons were, we are talking about the second quarter of 2009, when the world essentially was coming to an end. Remember, at the end of 2008, beginning of 2009 we all thought the world had ended. The markets hit bottom in March 2009, well those were the comparisons we were up against. So things are actually better then people were expecting, but they should have looked back to see what the comparisons were and remember, the governments were spending huge amounts of money and that money has been flowing into the system in the last couple of quarters. Worry about next year, don`t worry about the second quarter now, that`s history.
in CNBC
Related ETFs: iShares FTSE/Xinhua China 25 Index (ETF) (NYSE:FXI), iShares MSCI Brazil Index (ETF) (NYSE:EWZ), iShares MSCI South Korea Index Fund(ETF) (NYSE:EWY), iShares MSCI Emerging Markets Indx (ETF) (NYSE:EEM)
Jim Rogers is an author, financial commentator and successful international investor. He has been frequently featured in Time, The New York Times, Barron’s, Forbes, Fortune, The Wall Street Journal, The Financial Times and is a regular guest on Bloomberg and CNBC.
Earnings Season: Worry About Next Year, The Second Quarter Is History
I think some of it is expectation management as you put it out, but remember what the comparisons were, we are talking about the second quarter of 2009, when the world essentially was coming to an end. Remember, at the end of 2008, beginning of 2009 we all thought the world had ended. The markets hit bottom in March 2009, well those were the comparisons we were up against. So things are actually better then people were expecting, but they should have looked back to see what the comparisons were and remember, the governments were spending huge amounts of money and that money has been flowing into the system in the last couple of quarters. Worry about next year, don`t worry about the second quarter now, that`s history.
in CNBC
Related ETFs: iShares FTSE/Xinhua China 25 Index (ETF) (NYSE:FXI), iShares MSCI Brazil Index (ETF) (NYSE:EWZ), iShares MSCI South Korea Index Fund(ETF) (NYSE:EWY), iShares MSCI Emerging Markets Indx (ETF) (NYSE:EEM)
Jim Rogers is an author, financial commentator and successful international investor. He has been frequently featured in Time, The New York Times, Barron’s, Forbes, Fortune, The Wall Street Journal, The Financial Times and is a regular guest on Bloomberg and CNBC.
Sunday, August 1, 2010
News Bites 1 Aug 2010
- SHAWN Bergerson, founder of Waterstone Capital Management LP, bet against convertible bonds of Advanced Micro Devices Inc in June 2007. More than a year later, he reversed course and bought the securities. After riding the rebound by markets in 2009, he's wagering against consumer-related stocks because he sees Americans curtailing spending and reducing debt amid high unemployment.
- Mr O'Shea, who runs COMAC Capital LLP, and Laurence Benedict of Banyan Equity Management LLC said they have reduced the size of their investments because it's hard to know how markets will behave.
- Mr Gerstenhaber is planning to bet against industries that do poorly when the economy loses steam, such as materials, energy and homebuilders. 'Our expectation is that we will continue to see downward revisions to growth forecasts in advanced economies,' Mr Gerstenhaber, 49, said. The US$1 billion Argonaut Macro returned a cumulative 48 per cent from the start of 2007 through June 2010.
- The winning-streak managers made money through a combination of prescient investment calls, having smaller trades for shorter periods of time, which enabled them to get out of unprofitable positions sooner, and raising cash before markets slumped in the second half of 2008.
- In a 60 Minutes interview on June 7last year, US Federal Reserve Chairman Ben S Bernanke said: 'Well, I absolutely agree that confidence is key. People don't know what's happening. And they're afraid. And they're not sure what, you know, whether or not the system is going to recover. So, how do you get confidence, that's the question. And I think the way to get confidence is to show progress.'
- Thomson Reuters/University of Michigan preliminary index of consumer sentiment fell to 66.5 in July from 76 a month earlier, below forecasts. Readings on consumer expectations and current conditions also fell in early July from June. The expectations reading fell to 60.6, the lowest level since March 2009, from 69.8. Meanwhile, the current-conditions reading declined to 75.5, the lowest since November, from 85.6.
- This week, the Conference Board's consumer confidence index, which had declined in June, retreated even further in July. The index now stands at 50.4, down from 54.3 in June. It is made up of the present situation index, which decreased to 26.1 from 26.8, and the expectations index, which, relating to conditions six months ahead, fell to 66.6 from 72.7 last month.
- Mr O'Shea, who runs COMAC Capital LLP, and Laurence Benedict of Banyan Equity Management LLC said they have reduced the size of their investments because it's hard to know how markets will behave.
- Mr Gerstenhaber is planning to bet against industries that do poorly when the economy loses steam, such as materials, energy and homebuilders. 'Our expectation is that we will continue to see downward revisions to growth forecasts in advanced economies,' Mr Gerstenhaber, 49, said. The US$1 billion Argonaut Macro returned a cumulative 48 per cent from the start of 2007 through June 2010.
- The winning-streak managers made money through a combination of prescient investment calls, having smaller trades for shorter periods of time, which enabled them to get out of unprofitable positions sooner, and raising cash before markets slumped in the second half of 2008.
- In a 60 Minutes interview on June 7last year, US Federal Reserve Chairman Ben S Bernanke said: 'Well, I absolutely agree that confidence is key. People don't know what's happening. And they're afraid. And they're not sure what, you know, whether or not the system is going to recover. So, how do you get confidence, that's the question. And I think the way to get confidence is to show progress.'
- Thomson Reuters/University of Michigan preliminary index of consumer sentiment fell to 66.5 in July from 76 a month earlier, below forecasts. Readings on consumer expectations and current conditions also fell in early July from June. The expectations reading fell to 60.6, the lowest level since March 2009, from 69.8. Meanwhile, the current-conditions reading declined to 75.5, the lowest since November, from 85.6.
- This week, the Conference Board's consumer confidence index, which had declined in June, retreated even further in July. The index now stands at 50.4, down from 54.3 in June. It is made up of the present situation index, which decreased to 26.1 from 26.8, and the expectations index, which, relating to conditions six months ahead, fell to 66.6 from 72.7 last month.
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