Friday, October 17, 2008

What's to Come?

John Cassidy writes an interesting review of George Soros' new book "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means" in the New York Review of Books this month. The review is titled "He Foresaw the End of an Era" and it discusses Soros opinion of the credit crisis we are enduring, and how it came about. Soros is apparently at odds with the popular orthodoxy, the Chicago school of economics, an approach championed by the likes of Milton Friedman that favors less government intervention in favor of reliance on the rational expectations of the market to provide a sufficient check on excess speculation and investment. Of course this school of thought assumes that actors in the market will behave rationally at all times, or at least frequently enough and in great enough numbers to prevent the market in general from acting against its own short or long-term interests. This is the approach that Alan Greenspan (and most American economists) adhered to, and it is reflected in comments he made before the Senate rebuffing calls for greater regulation of the derivatives market: “Risks in financial markets, including derivatives markets, are being regulated by private parties...There is nothing involved in federal regulation per se which makes it superior to market regulation.”Soros disagrees with this approach, believing that incorrect assumptions and perceptions cause people to work against their own interests, and that doing so can even fuel misperception. Here is an excerpt from his book that Cassidy highlights:

Reflexivity can be interpreted as a circularity, or two-way feedback loop, between the participants' views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation (the manipulative function), and changes in the situation are liable to change their perceptions (the cognitive function).

Cassidy explains with an example:

Imagine that ABC Corp. makes profits of $W per share, pays dividends of $X a share, and is growing at Y percent per annum. If you assume that this rate of earnings growth will persist indefinitely, it is a matter of high school arithmetic to figure out what ABC Corp.'s stock is worth on a fundamental basis, an amount I will call $Z. In the world of the Chicago economists, well-informed investors bid the price up to $Z and stop there. If prices rise above that level, they step in and sell; if prices fall below $Z, they buy. All is rational: all is efficient.

Now imagine that a group of irrationally exuberant investors come to believe that ABC Corp.'s growth rate is about to accelerate to 2Y percent, and, as a result, they bid up its stock up $2Z and keep it there for a while. What happens next? One possibility is that ABC Corp. could issue more of its highly rated shares and use them to purchase a rival, DEF Corp., whose stock price has been lagging—hence presenting a relative bargain. Thanks to the magic of acquisition accounting, the mere act of ABC Corp. buying DEF Corp. would make it appear that its earnings per share were growing rapidly. Voil√†, the inflated earnings expectations that drove up ABC Corp.'s stock would have turned out to be justified. Most likely, the stock would rise even further—for a while, anyway.

As Cassidy explains, Soros did something to this effect when he was younger, leading a wave of mergers that artificially drove up the stock price of under-performing companies. At least, it did until the under-performing companies ran out of high performing companies to buy out, upon which the scheme collapsed as investors realized there was no real added value to the under-performing company. But Soros was gone before this happened, having made millions in the process. Soros behaved quite rationally, but for the other investors who genuinely believed that their stock price was skyrocketing, the popping of the merger bubble was what deflated their irrational exuberance...costing them millions in the process.

Soros goes onto explain how this irrational behavior led to the present crisis:

Turning to the current situation, he says that, in large part, the recent housing bubble in the United States fit the historic pattern, except that in this case reflexivity was centered on the real estate rather than the stock market. As house prices shot up between 2001 and 2005, credit standards deteriorated sharply. Rather than restricting their lending, mortgage financiers deluded themselves into believing that the collateral for the loans they were making would continue to rise in value. The very act of extending more and more credit, on easier and easier terms, kept demand for real estate buoyant, which, in turn, ensured that for several years the lenders' optimistic expectations were validated. It was only when borrowers who had taken out loans they couldn't afford started to default in large numbers that the housing bubble finally burst.

What distinguishes this process from earlier downturns, and what makes it so dangerous, is the historical and international economic situation in which it is taking place, Soros says. "Superimposed on the US housing bubble," he writes, "is a much larger boom-bust sequence which has finally reached its inflection, or crossover, point." The housing slump is following the normal historical pattern, he suggests.

As described by Soros, the "super-bubble" developed over the past quarter-century and is the result of three underlying trends: globalization, credit expansion, and deregulation. By globalization, he means not just expansion of trade in goods and services, and the rise of China and India, but the US's emergence as the world's biggest debtor. In the past couple of years, he reminds us, the United States has been running a current account deficit of more than 6 percent of GDP—a level usually associated with a developing country about to suffer a foreign exchange crisis.

The lending boom extended far beyond the housing market. Over the past generation, the overall expansion of the US economy has increasingly become an asset-driven phenomenon. In 1980, the total amount of credit market debt outstanding in the United States was roughly the same as the GDP: by 2007, it had risen to about 350 percent of GDP. The bundling of residential mortgages into widely traded securities—"securitization"—played a significant role in this transformation, but so did increased federal lending resulting from large-scale budget deficits, the securitization of credit card debt and auto loans, and an expansion in corporate debt issuance.

You may recall an earlier post where I quoted economist Satyajit Das, who said "Essentially, the world has just has far too much debt." Soros echoes this sentiment. Debt has driven the U.S. economy at all levels, from the individual consumer to the corporate conglomerate to the giant investment bank to the U.S. government. We are awash in debt because, for a decades, it has seemed entirely rational to incur vast amounts of debt to in turn invest that debt in something else, and as long as the collateral the debt is premised on retain its value this approach works. But when the housing bubble burst, the value of mortgage backed securities plummeted, and in turn so did the value of derivatives keyed to those securities, on the orders of tens of trillions of dollars. Vast sums were premised on the idea that houses in the U.S. would not only retain what value they had, but continue to increase in value; thus, in this view, mortgage backed securities were a wise investment that would never decline in value. Unfortunately for all of us, this was a misunderstanding of the forces at play. Easy credit drove up housing prices, and the increase in value resulted in more easy credit; a cycle that was self-reinforcing and completely insupportable and that came to a quick end when what homeowners borrowed began to outstrip even the small amounts they were being asked to pay. The housing market is now correcting itself but unfortunately, so is the market for the trillions in investment premised on the inflated value of homes.

So where do we go from here? Soros again:

So what does the end of an era really mean? I contend that it means the end of a long period of relative stability based on the United States as the dominant power and the dollar as the main international reserve currency. I foresee a period of political and financial instability, hopefully to be followed by the emergence of a new world order.

The present debate bears out Soros' remarks. This article wonders if American capitalism as we know it (the lasseiz-faire, anti-regulation approach) is at an end, and European leaders are presently debating what system should replace it with French President Nicholas Sarkozy calling to "re-found the capitalist system." It seems clear though that what is in order is a fundamental re-evaulation not only of our approach towards regulation of the market, but of the value of a debt as an engine of economic progress. What drove investment in mortgage backed securities and derivatives in general is the need of those with excess funds to do something with all that money they have, beyond simply sitting it in a bank. But what drove speculation far beyond the actual ability of most firms to account for what they owed, was the ability to borrow far more than they should have been able to and in turn leverage that into investments that were fundamentally unsound. Few on Wall Street thought it strange that an investment fund could borrow on the order or tens or hundreds times more what capital it possessed, and nobody wanted to look to closely at this scheme anyway, so long as everyone was making money. But of course such massive debt seems blatantly and obviously wrong to you and I, just as it seems wrong that a homeowner making $50,000 a year could borrow $500,000 to buy a house (though nobody wanted to look too closely at that either, so long as everyone was making money.) But the market failed to accurately price the risk inherent in mortgage backed securities (in fact, the market was eager to price the incorrectly so they could be sold to others) even though rationally, market actors should question the vast sums of debt and wonder who will finally get paid what and when. Regulation is in order, but the days of easy credit for both consumers and financiers also appear to be at and end as the value of vast amounts of debt contracts (and our economy contracts with it.) The old approach to the market is dead; what will replace it?

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