26 May 2008

The Trillion Dollar Meltdown

The Trillion Dollar Meltdown by Charles Morris and The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means by George Soros:
The Sunday Times review by Edward Chancellor
For several years, debt has been growing faster than incomes in most corners of the English-speaking world. Our economic high priests claimed there was nothing to fear. Sure, there was more debt around, but the architecture of the financial system was more robust and could bear more strain. Then last summer, the great edifice of credit started to collapse. How we arrived here and what it means is the subject of two timely books.

Charles Morris's The Trillion Dollar Meltdown has many excellent qualities besides brevity. In fewer than 200 pages, Morris provides a comprehensive and jargon-free description of the hideously complex financial securities that have brought the credit system to collapse. It is a remarkable story. In the 10 years to the beginning of 2007, Americans borrowed a staggering $9 trillion against their home equity. This surge of credit contributed greatly to the prosperity that Anglo-Saxon economies have enjoyed over the past decade.

Yet credit was plentiful only because lenders had abdicated their traditional role. Bankers discovered how to package loans, insure them, and sell them off. As a result, the credit system turned into a game of hot potato. But last summer, the music stopped and Bear Stearns, a Wall Street bank that had been particularly aggressive in the mortgage field, was left holding the hot potato. By February, the prospect of Bear's bankruptcy sent the financial world into convulsions and the Federal Reserve was forced to embark on a multibillion-dollar bailout.

While the financial crisis is not just about souring mortgages provided to the least creditworthy American home-buyers, subprime loans are a fitting symbol of what went wrong. Creditors might normally be expected to have two thoughts uppermost in their mind: the return of principal and the receipt of sufficient interest to cover prospective losses. This was not the case with subprime loans. The fact that these had little prospect of being repaid bothered no one. Everyone in the credit system (the home appraisers, mortgage brokers, lending banks, Wall Street firms that acquired bundles of mortgages and sold them on, ratings agencies that stamped these securities with their investment-grade imprimatur, as well as the hedge funds that snapped up the riskiest slices of debt) was primarily concerned with fees. This encouraged reckless and predatory lending.

Buy the books here
Morris points out that the new credit system actually favoured riskier loans because they meant higher rates and produced more “spread” for market participants to play with. When the American housing market turned down, lenders turned to financing leveraged buyouts - the subprimes of the corporate world. Clever bankers even found a way to create debt securities when there was no bona fide borrower. Frankenstein securities, which replicated real loans, were constructed out of credit insurance contracts. The supply of credit became infinite, utterly divorced from its traditional role of allocating scarce capital. Financial profits and bankers' bonuses soared.

Alan Greenspan, the chairman of the Federal Reserve, repeatedly praised such financial innovation. He said that risk was better understood and better distributed, and hailed a “new paradigm of active credit management”. His Panglossian view - markets could be left to regulate themselves - blinded him to increasingly dubious activities in the credit markets.

George Soros, the billionaire investor and philanthropist, claims that free-market economists - or “market fundamentalists” - such as Greenspan, are responsible for the current crisis. In The New Paradigm for Financial Markets, Soros proposes an alternative model. Conventional economics holds that markets comprise rational and all-knowing participants and, as a result, tend towards equilibrium. Soros, however, maintains that man is incapable of perfect knowledge. In markets, he argues, people hold views and act upon their opinions. Yet their actions change the nature of what they observe. Soros calls his theory “reflexivity” (he first expounded this notion in his 1987 The Alchemy of Finance).

Economists pretend not to understand what Soros is on about. However, his central insight is intuitively obvious. Mortgage loans are provided because the lender believes houses are a good bet. But a ready supply of loans drives up the value of homes. Rising prices inflate collateral values, making bankers feel even more secure. Builders respond by increasing supply. Home prices, the supply of new homes, and provision of fresh credit escalate. At the start of every bubble is a plausible idea which in time becomes corrupted. The notion that American home prices were essentially stable was one such “fertile fallacy”.

Soros believes that the current crisis exposes the limits of the free-market ideology that has held sway since the early 1980s. Morris is like-minded. Both authors conclude that the crisis threatens to end the era of American financial supremacy, in which the dollar has served as the global reserve currency. Both see problems ahead as more corporate and commercial real estate loans go bad. It's time for a change in economic thinking, says Soros. The next generation of economists will have to understand financial bubbles rather than ignore them, as Greenspan and his fellow central bankers have done. They would be well advised to give Soros's theory of reflexivity serious consideration.

The Trillion Dollar Meltdown by Charles Morris
PublicAffairs £13.99 pp194
The New Paradigm for Financial Markets by George Soros
PublicAffairs £12.99 pp162

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