No Licenses to Kill
by George Soros
NEW YORK – In the last year, we endured a remarkable experience; after the bankruptcy of Lehman Brothers in September 2008, financial markets actually collapsed and required artificial life support. Nothing like this had happened since the Great Depression of the 1930’s.
What made this collapse so remarkable is that it was not caused by some external factor, but originated within the financial system itself and spread from there throughout the global economy. This was almost completely unexpected, as the prevailing view was that financial markets are self-correcting.
We now know that they are not. But, having gone too far in deregulating markets, we must resist a natural tendency to overcompensate. While markets are imperfect, regulators are not only human but bureaucratic and subject to political influence. Therefore, new regulations should be kept to a minimum.
Three principles should guide reform. First and foremost, financial authorities must accept responsibility for preventing asset bubbles from growing too big. Former United States Federal Reserve Chairman Alan Greenspan and others have argued that if markets can’t recognize bubbles, neither can regulators. Even so, financial authorities must accept the assignment: while they are bound to be wrong, feedback from the markets will tell them whether they have done too much or too little. They can then correct their mistakes.
Second, controlling asset bubbles requires control not only of the money supply, but also of the availability of credit. The best-known tools for this are margin requirements and minimum capital requirements. Similarly, financial authorities should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes in order to forestall real estate bubbles.
Regulators may also have to revive old tools. For example, we had no financial crises when central banks instructed commercial banks to limit their lending to particular economic sectors that they believed were overheating, such as real estate or consumer loans. The Chinese authorities do it today, and they also set the minimum deposits banks must maintain with the central bank.
Or consider the Internet bubble, which Greenspan recognized early but then did nothing to address. He rightly believed that reducing the money supply would have been too blunt an instrument to use. But he could have devised more specific measures, such as asking the Securities and Exchange Commission to freeze new share issues, because equity leveraging was fueling the bubble.
The Internet bubble was unusual in this regard. Usually, it is credit that provides the leverage, and credit is by nature reflexive. That is, an increase in the willingness to lend tends to increase the value of the collateral, and also improves the borrowers’ performance, thereby encouraging a relaxation of credit criteria. Bubbles recur, especially in real estate, because this reflexive relationship is repeatedly ignored.
This brings me to my third point: we must reconceptualize the meaning of market risk. According to conventional theory, markets tend towards equilibrium, function without any discontinuity in the sequence of prices, and deviations occur in a random fashion. As a result, market risks can be equated with the risks confronting individual market participants. As long as they manage their risks properly, regulators should be happy.
But markets are subject to imbalances that individual participants may ignore if they think they can offload their positions on someone else. Regulators, by contrast, cannot ignore these imbalances, because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, financial collapse.
Thus, there is systemic market risk, and unregulated securitization of banking assets, which was the main cause of the recent collapse, adds to it. To avert a repetition, securities held by banks must carry a much higher risk rating than they currently do. Banks must pay for their implicit government guarantee by using less leverage and accepting restrictions on how they invest depositors’ money.
At a minimum, proprietary trading ought to be financed by banks’ own capital. If a bank is too big to fail, regulators should go even further, and regulate proprietary traders’ compensation packages to ensure that risks and rewards are properly aligned. Hedge funds and other large investors must also be closely monitored to ensure that they don’t build up dangerous imbalances.
Moreover, the issuance and trading of derivatives ought to be at least as strictly regulated as that of stocks. Regulators should insist that traded derivatives are homogenous, standardized, and transparent. Some derivatives, particularly credit default swaps should not be traded at all.
To see why, note that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one’s risk exposure, while losing on a short position increases it, so one can be more patient being long and wrong than being short and wrong.
Now, the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Shorting bonds by purchasing a CDS contract carries limited risk but almost unlimited profit potential, whereas selling a CDS contract offers limited profits but practically unlimited risks. This encourages short-side speculation, which places downward pressure on the underlying bonds.
The negative effect is reinforced by the fact that, because CDS contracts are tradable, they tend to be priced as warrants, which can be sold at any time, rather than as options, which would require an actual default to be cashed in. People buy CDS contracts not because they expect a default, but because they expect the CDS to appreciate in response to adverse developments.
That is what destroyed AIG, and what led to the recent bankruptcy of Abitibi-Bowater and the pending bankruptcy of General Motors. In both cases, because some bondholders owned CDS contracts, they stood to gain more from bankruptcy than from reorganization.
Purchasing CDS contracts is like buying insurance on someone else’s life and owning a license to kill him. It is the job of regulators to ensure that no one is ever granted such a license.
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Saturday, July 4, 2009
Soros on Market Regulation
George Soros has made more money on markets than all who decry any regulation at all. He recognizes that to survive, we must master the markets or they will consume us.
at 10:56 AM