Soros on the failure of markets to self-regulate

George Soros decided to respond to my previous post by penning an editorial in today's FT. He is rather sanguine calling the credo that stable equilibrium is a given a "False Ideology at the heart of the financial crisis".

From the FT:

The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points.

Soros then rings two alarms: 1/CDS markets 2/jingle mail.

Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

What he is basically calling for is an exchange for these CDS. Transparency is what these markets really need first and foremost and therefore a clearing market would expose this "shadow banking" system. My brother deals in them in Europe, I will have to ask him what he thinks of this type of regulation :) Let there be light!

The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

He is calling for the govt intervention to stabilize housing prices and preventing them from collapsing further. The natural collapse as the market readjust is sure to continue wrecking havoc on the banking system. It is already under tremendous stress, if not insolvent as is, without further deterioration of the housing market.

He then indulges in bashing the Bush administration for its ideological goofiness:

The Bush administration has resisted using taxpayers’ money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed.

The Bush administration has NOT resisted using taxpayers' money. It has SPLURGED on it. The fact that the FED are committing 30B in Bear, swapping half its balance sheet ($400B) for dead-mice collateral and the tax-relief all are "using taxpayers money". I like it when there is political and ideological grand standing around questions of money. It doesn't mean anything, it is ideological, the rules are set, nothing that is said is relevant and only the money counts but you listen to the politicos :)

In fact one of the surest ways to know you are discussing ideology is when the debates get heated. Since there is no right or wrong, a debate degenerates into passionate defense of your favorite color. In questions of money, there is usually a right way, for example right now the modus operandi is "SAVE THE SYSTEM BY ANY MEANS NECESSARY", and because that way is so clear, nobody REALLY discusses it. It is much more fun to discuss the IMAGE we have of ourselves that of big boys on horses, wild free and afraid of nothing while sucking at the tit of the Fed any time there is a rumbling in the distance.