October 14, 2008
News & Opinion: The New Paradigm for Financial Markets
George Soros has led an extraordinary life, having survived Nazi Germany and Stalinist Russia to become one of the richest men in the world. He is one of the most successful financial speculators in the world, and as such, has a deep understanding of financial markets. He released a book in May, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, in which he stated "Eventually, the U.S. government will have to use taxpayer money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent..." That recently came to pass, to the tune of $700 billion dollars. Mr. Soros begins the book by soberly analyzing exactly how we got into this crisis, and we've excerpted that material below.
Setting the Stage
The outbreak of the current financial crisis can be officially fixed as August 2007. That was when the central banks had to intervene to provide liquidity to the banking system.
The crisis was slow in coming, but it could have been anticipated several years in advance. It had its origins in the bursting of the Internet bubble in late 2000. The Fed responded by cutting the federal funds rate from 6.5 percent to 3.5 percent within the space of just a few months. Then came the terrorist attack of September 11, 2001. To counteract the disruption of the economy, the Fed continued to lower rates--all the way down to 1 percent by July 2003, the lowest rate in half a century, where it stayed for a full year. For thirty-one consecutive months the base inflation-adjusted short-term interest rate was negative.
Cheap money engendered a housing bubble, an explosion of leveraged buyouts, and other excesses. When money is free, the rational lender will keep on lending until there is no one else to lend to. Mortgage lenders relaxed their standards and invented new ways to stimulate business and generate fees. Investment banks on Wall Street developed a variety of new techniques to hive credit risk off to other investors, like pension funds and mutual funds, which were hungry for yield. They also created structured investment vehicles (SIVs) to keep their own positions off their balance sheets.
From 2000 until mid-2005, the market value of existing homes grew by more than 50 percent, and there was a frenzy of new construction. Merrill Lynch estimated that about half of all American GDP growth in the first half of 2005 was housing related, either directly, through home building and housing-related purchases like new furniture, or indirectly, by spending the cash generated from the refinancing of mortgages. Martin Feldstein, a former chairman of the Council of Economic Advisers, estimated that from 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. A 2005 study led by Alan Greenspan estimated that in the 2000s, home equity withdrawals were financing 3 percent of all personal consumption. By the first quarter of 2006, home equity extraction made up nearly 10 percent of disposable personal income.
Double-digit price increases in house prices engendered speculation. When the value of property is expected to rise more than the cost of borrowing, it makes sense to own more property than one wants to occupy. By 2005, 40 percent of all homes purchased were not meant to serve as permanent residences but as investments or second homes. Since growth in real median income was anemic in the 2000s, lenders strained ingenuity to make houses appear affordable. The most popular devices were adjustable rate mortgages (ARMs) with "teaser," below-market initial rates for an initial two-year period. It was assumed that after two years, when the higher rate kicked in, the mortgage would be refinanced, taking advantage of the higher prices and generating a new set of fees for the lenders. Credit standards collapsed, and mortgages were made widely available to people with low credit ratings (called subprime mortgages), many of whom were well-to-do. "Alt-A" (or liar loans), with low or no documentation, were common, including, at the extreme, "ninja" loans (no job, no income, no assets), frequently with the active connivance of the mortgage brokers and mortgage lenders.
Banks sold off their riskiest mortgages by repackaging them into securities called collateralized debt obligations (CDOs). CDOs channeled the cash flows from thousands of mortgages into a series of tiered, or tranched, bonds with risks and yields tuned to different investor tastes. The top-tier tranches, which comprised perhaps 80 percent of the bonds, would have first call on all underlying cash flows, so they could be sold with a AAA rating. The lower tiers absorbed first-dollar risks but carried higher yields. In practice, the bankers and the rating agencies grossly underestimated the risks inherent in absurdities like ninja loans.
Securitization was meant to reduce risks through risk tiering and geographic diversification. As it turned out, they increased the risks by transferring ownership of mortgages from bankers who knew their customers to investors who did not. Instead of a bank or savings and loan approving a credit and retaining it on its books, loans were sourced by brokers; temporarily "warehoused" by thinly capitalized "mortgage bankers"; then sold en bloc to investment banks, who manufactured the CDOs, which were rated by ratings agencies and sold off to institutional investors. All income from the original sourcing through the final placement was fee based—the higher the volumes, the bigger the bonuses. The prospect of earning fees without incurring risks encouraged lax and deceptive business practices. The subprime area, which dealt with inexperienced and uninformed customers, was rife with fraudulent activities. The word "teaser rates" gave the game away.
Starting around 2005, securitization became a mania. It was easy and fast to create "synthetic" securities that mimicked the risks of real securities but did not carry the expense of buying and assembling actual loans. Risky paper could therefore be multiplied well beyond the actual supply in the market. [...] Towards the end, synthetic products accounted for more than half the trading volume.
The securitization mania was not confined to mortgages and spread to other forms of credit. By far the largest synthetic market is constituted by credit default swaps (CDSs). This arcane synthetic financial instrument was invented in Europe in the early 1990s. Early CDSs were customized agreements between two banks. Bank A, the swap seller (protection purchaser), agreed to pay an annual fee for a set period of years to Bank B, the swap buyer (protection seller), with respect to a specific portfolio of loans. Bank B would commit to making good Bank A's losses on portfolio defaults during the life of the swap. Prior to CDSs, a bank wishing to diversify its portfolio would need to buy or sell pieces of loans, which was complicated because it required the permission of the borrower; consequently, this form of diversification became very popular. Terms were standardized, and the notional value of the contracts grew to about a trillion dollars by 2000.
Hedge funds entered the market in force in the early 2000s. Specialized credit hedge funds effectively acted as unlicensed insurance companies, collecting premiums on the CDOs and other securities that they insured. The value of the insurance was often questionable because contracts could be assigned without notifying the counterparties. The market grew exponentially until it came to overshadow all other markets in nominal terms. The estimated nominal value of CDS contracts outstanding is $42.6 trillion. To put matters in perspective, this is equal to almost the entire household wealth of the United States. The capitalization of the U.S. stock market is $18.5 trillion, and the U.S. treasuries market is only $4.5 trillion.
It was bound to end badly. There was a precedent to go by. The market in collateralized mortgage obligations (CMOs) started to develop in the 1980s. In 1994, the market in the lowest-rated tranches--or "toxic waste," as they were known--blew up when a $2 billion hedge fund could not meet a margin call, leading to the demise of Kidder Peabody and total losses of about $55 billion. But no regulatory action was taken. [...]
Signs of trouble started to multiply early in 2007. On February 22, HSBC fired the head of its U.S. mortgage lending business, recognizing losses reaching $10.8 billion. On
March 9, DR Horton, the biggest U.S. homebuilder, warned of losses from subprime mortgages. On March 12, New Century Financial, one of the biggest subprime lenders, had its shares suspended from trading amid fears that the company was headed for bankruptcy. On March 13, it was reported that late payments on mortgages and home foreclosures rose to new highs. On March 16, Accredited Home Lenders Holding put up $2.7 billion of its subprime loan book for sale at a heavy discount to generate cash for business operations. On April 2, New Century Financial filed for Chapter 11 bankruptcy protection after it was forced to repurchase billions of dollars worth of bad loans.
On June 15, 2007, Bear Stearns announced that two large mortgage hedge funds were having trouble meeting margin calls. Bear grudgingly created a $3.2 billion credit line to bail out one fund and let the other collapse. Investors' equity of $1.5 billion was mostly wiped out.
The failure of the two Bear Stearns mortgage hedge funds in June badly rattled the markets, but U.S. Federal Reserve Chairman Ben Bernanke and other senior officials reassured the public that the subprime problem was an isolated phenomenon. Prices stabilized, although the flow of bad news continued unabated. As late as July 20, Bernanke still estimated subprime losses at only about $100 billion. When Merrill Lynch and Citigroup took big write-downs on in-house collateralized debt obligations, the markets actually staged a relief rally. The S&P 500 hit a new high in mid-July.
It was only at the beginning of August that financial markets really took fright. It came as a shock when Bear Stearns filed for bankruptcy protection for two hedge funds exposed to subprime loans and stopped clients from withdrawing cash from a third fund. As mentioned, Bear Stearns had tried to save these entities by providing $3.2 billion of additional funding.
Once the crisis erupted, financial markets unraveled with remarkable rapidity. Everything that could go wrong did. A surprisingly large number of weaknesses were revealed in a remarkably short period of time. What started with low-grade subprime mortgages soon spread to CDOs, particularly those synthetic ones that were constructed out of the top slice of subprime mortgages. The CDOs themselves were not readily tradable, but there were tradable indexes representing the various branches. Investors looking for cover and short sellers looking for profits rushed to sell these indexes, and they declined precipitously, bringing the value of the various branches of CDOs that they were supposed to represent into question. Investment banks carried large positions of CDOs off balance sheet in so-called structured investment vehicles (SIVs). The SIVs financed their positions by issuing asset-backed commercial paper. As the value of CDOs came into question, the asset-backed commercial paper market dried up, and the investment banks were forced to bail out their SIVs. Most investment banks took the SIVs into their balance sheets and were forced to recognize large losses in the process. Investment banks were also sitting on large loan commitments to finance leveraged buyouts. In the normal course of events, they would package these loans as collateralized loan obligations (CLOs) and sell them off, but the CLO market came to a standstill together with the CDO market, and the banks were left holding a bag worth about $250 billion. Some banks allowed their SIVs to go bust, and some reneged on their leveraged buyout obligations. This, together with the size of the losses incurred by the banks, served to unnerve the stock market, and price movements became chaotic. So-called market-neutral hedge funds, which exploit small discrepancies in market prices by using very high leverage, ceased to be market neutral and incurred unusual losses. A few highly leveraged ones were wiped out, damaging the reputation of their sponsors and unleashing lawsuits.
All this put tremendous pressure on the banking system. Banks had to put additional items on their balance sheets at a time when their capital base was impaired by unexpected losses. They had difficulty assessing their exposure and even greater difficulties estimating the exposure of their counterparts. Consequently they were reluctant to lend to each other and eager to hoard their liquidity. At first, central banks found it difficult to inject enough liquidity because commercial banks avoided using any of the facilities which had an onus attached to them, and they were also reluctant to deal with each other, but eventually these obstacles were overcome. After all, if there is one thing central banks know how to do, that is to provide liquidity. Only the Bank of England suffered a major debacle when it attempted to rescue Northern Rock, an overextended mortgage lender. Its rescue effort resulted in a run on the bank. Eventually Northern Rock was nationalized and its obligations added to the national debt, pushing the United Kingdom beyond the limits imposed by the Maastricht Treaty.
Although liquidity had been provided, the crisis refused to abate. Credit spreads continued to widen. Almost all the major banks--Citigroup, Merrill Lynch, Lehman Brothers, Bank of America, Wachovia, UBS, Credit Suisse--announced major write-downs in the fourth quarter, and most have signaled continued write-downs in 2008. Both AIG and Credit Suisse made preliminary fourth-quarter write-down announcements that they repeatedly revised, conveying the doubtless accurate impression that they had lost control of their balance sheets. A $7.2 billion trading fiasco at Société Générale announced on January 25, 2008, coincided with a selling climax in the stock market and an extraordinary 75 basis point cut in the federal funds rate eight days before the regularly scheduled meeting, when the rate was cut a further 50 basis points. This was unprecedented.
Distress spread from residential real estate to credit card debt, auto debt, and commercial real estate. Trouble at the monoline insurance companies, which traditionally specialized in municipal bonds but ventured into insuring structured and synthetic products, caused the municipal bond market to be disrupted. An even larger unresolved problem is looming in the credit default swaps market.
Over the past several decades the United States has weathered several major financial crises, like the international lending crisis of the 1980s and the savings and loan crisis of the early 1990s. But the current crisis is of an entirely different character. It has spread from one segment of the market to others, particularly those which employ newly created structured and synthetic instruments. Both the exposure and the capital base of the major financial institutions have been brought into question, and the uncertainties are likely to remain unresolved for an extended period of time. This is impeding the normal functioning of the financial system and is liable to have far-reaching consequences for the real economy.
Both the financial markets and the financial authorities have been very slow to recognize that the real economy is bound to be affected. It is hard to understand why this should be so. The real economy was stimulated by credit expansion. Why should it not be negatively affected by credit contraction? One cannot escape the conclusion that both the financial authorities and market participants harbor fundamental misconceptions about the way financial markets function. These misconceptions have manifested themselves not only in a failure to understand what is going on; they have given rise to the excesses which are at the root of the current market turmoil.
Excerpted from The New Paradigm for Financial Markets
Copyright © 2008 by George Soros.
Published in the United States by PublicAffairs™,
a member of the Perseus Books Group.