CREDIT DEFAULT SWAPS SHOULD BE OUTLAWED -- Soros

As a pointed out by way of this post CDO/CDS are a means of unregulated credit creation.

George Soros has finally had a chance to figure out what these CDS things are all about. And he's had enough:

BEIJING, June 12 (Reuters) - Credit default swaps are "instruments of destruction" that should be outlawed, billionaire investor George Soros said on Friday.

Soros said the asymmetry of risk and reward embedded in CDS exerted so much downward pressure on the bonds underlying the contracts that companies and financial institutions could be brought to their knees.

"Some derivatives ought not to be allowed to be traded at all. I have in mind credit default swaps. The more I've heard about them, the more I've realised they're truly toxic," he told a banking conference.

"CDS are instruments of destruction which ought to be outlawed," Soros told a meeting of the Institute of International Finance, many of whose member banks and financial institutions are active participants in the huge CDS market.

Going short on bonds by purchasing a CDS contract carried limited risk but almost unlimited profit potential. By contrast, selling CDSs offered limited profit and practically unlimited risk, Soros said.

This asymmetry, which encouraged investors in effect to sell corporate bonds short, was reinforced by the fact that CDS were traded and so tended to be priced as warrants, which could be sold at any time, and not as options, he added.

Credit default swaps are used to protect against nonpayment of debt or to speculate on a company's credit quality.


But Soros said: "People buy a CDS not because they expect an eventual default but because they expect them to appreciate in response to adverse developments."

SKEWED INCENTIVES

He said one financial institution that discovered to its cost the risk/reward distortions of CDS was insurer American International Group (AIG.N), which was a big seller of CDS, offering banks protection against a deterioration in their bond portfolios, especially mortgage-linked securities.

The U.S. government stepped in to save AIG from collapse under bad mortgage bets last September, and has put up to $180 billion at the company's disposal since.

"AIG thought it was selling insurance on bonds and as such CDS were outrageously overpriced. In fact AIG was selling bear market warrants and it severely underestimated their value," Soros said.

At this point, the phenomenon that Soros describes as reflexivity kicked in. That is to say, the mispricing of financial instruments -- in this case, CDS -- affected the fundamentals that the prices were supposed to reflect.

Nowhere were the consequences of the ensuing chain reaction more severe than in the case of financial institutions, whose ability to do business depended on trust, Soros argued. He cited the failures of Bear Stearns and Lehman Brothers.

But the potential damage that CDS could do was not limited to financial firms, Soros added. He pointed to the bankruptcy of North America's largest newsprint maker, AbitibiBowater Inc (ABWTQ.PK), and the pending bankruptcy of General Motors (GM.N)

"In both cases, some bondholders owned CDS and they stood to gain more by bankruptcy than by reorganisation.

"It's like buying life insurance on someone else's life and owning a license to kill," he concluded.

Soros' criticism echoes fellow investor Warren Buffet's description of derivatives in 2003 as "financial weapons of mass destruction".

On derivatives in general, Soros said they should be as strictly regulated as stocks.

He said derivatives should be standardised and saw no case for custom-made derivatives, which he said only increased the profit margins of the financiers who tailored them.

(Reporting by Alan Wheatley; Editing by Chris Lewis)

http://www.businessinsider.com/henry-blodget-credit-default-swaps-should-be-outlawed-soros-2009-6

Soros interview inflation is coming..

After the financial market collapsed last fall, the Fed responded with a massive injection of liquidity and expansion of the monetary base.

Eventually, Ben Bernanke & Co. will face the challenge of having to remove that liquidity from the system. "That's a big and difficult task and probably the authorities will not be able to do it well," says legendary financier George Soros, chairman of Soros Fund Management. "That's the fear that drives people into gold."

Soros wouldn't say whether he's actively trading gold but certainly implied it's a good bet; more explicitly, he agreed with the view there's a "bubble" in Treasuries that's likely to burst sooner rather than later.

"The moment this fear of deflation turns into a fear of inflation, you'll find interest rates rise in the long end which is going to choke off the recovery," he says. "If we are successful [in reviving the economy] we are heading from the prospect of deflation to stagflation."

Watch the interview

Soros says U.S. faces "lasting slowdown"~ "Square Root" recovery

NEW YORK (Reuters) - The U.S. economy is in for a "lasting slowdown" and could face a Japanese-style period of relatively low growth with the added problem of high inflation, billionaire investor George Soros said on Monday.

Soros told Reuters Financial Television that rescuing U.S. banks could turn them into "zombies" that suck the lifeblood of the economy, prolonging the economic slowdown.

"I don't expect the U.S. economy to recover in the third or fourth quarter so I think we are in for a pretty lasting slowdown," Soros said, adding that in 2010 there might be "something" in terms of U.S. growth.

Most economists expect the U.S. economy to stop contracting in the third quarter and resume growing in the fourth quarter, according to a latest monthly poll of forecasts by Reuters.

The recovery will look like "an inverted square root sign," Soros said: "You hit bottom and you automatically rebound some, but then you don't come out of it in a V-shape recovery or anything like that. You settle down -- step down."

In the fourth quarter, the U.S. economy contracted at a 6.3 percent annualized rate, and economists think the first quarter's slide will be at least as severe, if not worse.

Healing the banking system, which is "basically insolvent," and housing markets is crucial to recovery, Soros said.

The public-private investment funds -- unveiled by the Treasury last month to get bad debts off bank balance sheets -- are going to work but won't be enough to recapitalize the banks so they are able to or willing to provide credit, he said.

Even a steep yield curve won't generate enough profits to keep the banks out of their vulnerable situation.

"What we have created now is a situation where the banks who will be able to earn their way out of a hole, but by doing that, they are going to weigh on the economy.

"Instead of stimulating the economy, they will draw the lifeblood, so to speak, of profits away from the real economy in order to keep themselves alive."

Soros, whose latest book, "The Crash of 2008 and What it Means," has made prescient calls during the credit crisis.

A year ago, he told Reuters that global losses were likely to top $1 trillion. U.S. and European banks have recorded more than $700 billion in losses and write-downs, as of February 5, 2009, according to Reuters data.

DOLLAR IS VULNERABLE

Soros said the "stress tests" of banks being conducted by Treasury, to determine their financial resilience, could be a precursor to a more successful recapitalization of the banks.

He also said the U.S. dollar is under selling pressure and one day could be replaced as a world reserve currency, possibly by the International Monetary Fund's Special Drawing Rights, a currency basket comprising dollars, euros, yen and sterling.

"I think the dollar is now under question and I think the system will need to be reformed, so that the United States will be subject to the same discipline as is imposed on other countries," said Soros, whose famous bet against the British pound earned his Quantum Fund $1 billion in 1992.

"Being the main issuer of international currency, we have been exempt and we have abused that because we have effectively consumed 6.5 percent more than we have produced. That is now coming to an end."

Soros said there was a risk of a "tipping point" for the dollar which would see it slump, triggering higher interest rates and choking growth.

"This leads you to what used to be stagflation -- stop, go. And I think that is what's probably in store, rather than... hyperinflation."

China recently proposed greater use of SDRs, possibly as an eventual global reserve currency.

"In the long run, having an international accounting unit rather than the dollar may, in fact, be to our advantage so we can't splurge -- you know, it felt very good for 25 years but now we are paying a very heavy price," Soros said.

U.S. consumer spending has to fall to 60 percent of gross domestic product, compared two-thirds now, he continued.

China will emerge first from recession, probably this year, and will lead global growth in 2010, Soros added.

World policymakers are "actually beginning to catch up" with the crisis and efforts to fix structural problems in the financial system, he said referring to last week's meeting of leaders of G20 countries.

Turning to Europe, the euro has been "a tremendous advantage" to countries that use it, adding there's "no question of a weaker country dropping out," Soros said.

More funds for the IMF will help it stabilize struggling Eastern Europe but the Baltic states still face "serious problems" and Ukraine is not far from default, he warned.

Widespread use of credit default swaps has worsened the risks for Europe, he said, though he added that Germany, the euro zone's biggest economy, is becoming more open to offering help. "Germany, which has been the most reserved about being the deep pocket of the rest of Europe, has recognized that it too has a responsibility toward the new member states."

Germany has been one of the most reluctant major economies to meet U.S. calls for more fiscal stimulus spending to boost the global economy and fight the financial crisis.

(Additional reporting by Martin Howell, Jack Reerink, Daniel Bases, William Schomberg and Steven C. Johnson; Editing by Jonathan Oatis; Editing by Diane Craft)

http://www.reuters.com/article/newsOne/idUSTRE53537D20090406?sp=true

G20 'make or break', Soros says

Billionaire investor Gorge Soros has said the G20 summit will be a "make or break" event for the world's economy.

In a BBC interview, Mr Soros said the international financial system had collapsed because it was flawed and it had to be restructured.

Mr Soros say it may be the last chance to prevent a full-scale depression.

He said the G20 meeting had to come up with concrete solutions to help the developing world in particular, which had been been worst hit.

'Depression'

Mr Soros warned that any attempt to pull economies out of recession had to be done co-operatively.

He said: "The G20 meeting is make or break because unless they do something for developing world there will be serious collapse in that part of the world.

"I'm using phrase depression because unless we take the right measures we're liable to end up there.

If countries start doing it [engineering a new financial world order] bilaterally instead of multilaterally, the system will fall apart and we'll end up in depression."

He also said the rebuilding meant the previous economic system had to be scrapped.
The International financial system has collapsed and cannot be restored in its current form
George Soros


"I don't think we'll ever be back to where we came from. It should be recognised that the last 25 years were an aberration and we cannot go back there. We have to reconstruct the financial system from its foundations up."

Mr Soros said regulators and the financial sector shared the blame for the meltdown, as they "participated in this crazy boom built on false premises on the belief that markets are self-regulating and should be left alone".

Mr Soros also warned the UK economy was in a deep recession "which is going to be a lasting one".

He added: "The International financial system has collapsed and cannot be restored in its current form. It will have to be restructured because it was flawed and collapsed under its own weight."

In May last year, Mr Soros was interviewed by the BBC's business editor Robert Peston and said he was worried about the US and UK's ability to deal with the downturn because of their reliance on credit.

Mr Soros urged wealthy nations to give their allocations of the IMF's internal currency, called Special Drawing Rights, to poorer ones because developing countries were not in a position to bail out their own failing banks.

George Soros famously made his name - and $1bn - when he bet that sterling would have to withdraw from the European Exchange Rate Mechanism in 1992. He's also said to have accurately predicted and profited from the Asian financial crisis in 1997.

The 78-year-old Hungarian is one of the largest aid donors in Africa, having donated around $6bn to his favourite causes.


http://news.bbc.co.uk/2/hi/business/7970199.stm

Its an ill wind ~ 'I'm having a very good crisis,' says Soros as hedge fund managers make billions off recession

A hedge fund manager who predicted the global credit crunch has said the financial crisis has been 'stimulating' and the culmination of his life's work.

George Soros, who predicted the global financial crisis twice before, was one of the few people to anticipate and prepare for the current economic collapse.

Mr Soros said his prediction meant he was better able to brace his Quantum investment fund against the gloabal storm.

But other investors failed to take notice of his prediction and his decision to come out of retirement in 2007 to manage the fund made him $US2.9 billion.

And while the financial crisis continued to deepen across the globe, the 78-year-old still managed to make $1.1 billion last year.

'It is, in a way, the culminating point of my life’s work,' he told national newspaper The Australian.

Soros is one of 25, top hedge fund managers from across Wall Street who have defied the credit crunch crisis to reap a total of $11.6billion (£7.9bn) last year.

The managers made their profit by trading above the pain in the markets, according to Institutional Investor’s Alpha Magazine.

Former maths professor James H. Simons, who has made billions in hedge fund Renaissance Technologies, earned $2.5 billion running computer-driven trading strategies.

And John A. Paulson, who made his fortune by betting against the housing market, came in second earning $2 billion.




Big hitters: John Paulson and James H Simons were part of a group of 25 hedge fund managers who make a total of $11.6bn

The managers made the profit in a year when losses were recorded at two of every three hedge funds and when hedge funds lost an average of 18 percent, according to the New York Times.

Two of the three managers who tied for ninth place, at $250 million, are based in Britain and include David Harding of Winton Capital and Alan Howard of Brevan Howard Asset Management.

Another Brevan Howard employee Christopher Rokos also made the list.

Its a systemic collapse: Soros

I beleive that has been the opinion of this blogger as well, there is no going back.

NEW YORK (Reuters) - Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.

Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union.

He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system.

"We witnessed the collapse of the financial system," Soros said at a Columbia University dinner. "It was placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom."

His comments echoed those made earlier at the same conference by Paul Volcker, a former Federal Reserve chairman who is now a top adviser to President Barack Obama.

Volcker said industrial production around the world was declining even more rapidly than in the United States, which is itself under severe strain.

"I don't remember any time, maybe even in the Great Depression, when things went down quite so fast, quite so uniformly around the world," Volcker said.

It has gone beyond my wildest imagination. ~ Soros

'The Economy Fell off the Cliff'

George Soros, 78, has made billions as a hedge-fund manager and investor. SPIEGEL spoke with him about the current financial crisis, how he expects President-elect Barack Obama to respond to the economic disaster and the responsibilities borne by speculators.

SPIEGEL: Mr. Soros, in spite of massive interventions by governments and federal banks the financial crisis is getting worse. The stock markets are in free fall, millions of people could lose their jobs. More and more companies are in trouble, from General Motors in Detroit to BASF in Ludwigshafen. Have you ever seen anything like it?

Soros: Never. I find the present situation dramatic and overwhelming. In my latest book “The New Paradigm for Financial Markets: The Credit Crisis of 2008” I predicted the worst financial crisis since the 1930s. But to tell you the truth: I did not actually anticipate that it would get as bad as it did. It has gone beyond my wildest imagination.

REUTERS

George Soros has made a fortune with hedge funds. "I find the present situation dramatic and overwhelming."

SPIEGEL: What are your fears for the coming months?


Soros: I think that the dark comes before dawn. The financial markets are under great pressure because of the lack of leadership during the transition period. In the next two months, the markets will experience maximum pressure. Then we will see some initiatives from the Obama administration. How long the crisis lasts will depend on the success of these measures.

SPIEGEL: The markets don't seem to have much confidence in the new president -- in stark contrast to the enthusiasm in the population. Since Election Day on November 4, stocks have fallen by almost 20 percent.

Soros: I have great hopes for Barack Obama. But at the time of the election the financial community had not yet fully grasped the magnitude of the economic decline. They did not anticipate that the default of Lehman Brothers would cause cardiac arrest in the markets. The economy fell off the cliff, you begin to see mangled bodies lying at the bottom.

SPIEGEL: Was it a policy mistake to let Lehman Brothers go bankrupt?

Soros: It was a fatal mistake. I would have never expected that the authorities let such a big investment bank go.

SPIEGEL: Will there be more victims?

Soros: Possibly. CitiBank, one of the world’s largest banks, is currently at the center of attention (eds. note: The $300 billion US government plan to stabilize CitiBank had not been approved by the time of this interview). There are some other bodies lined up for potential trouble. The situation is very similar to the 1930s -- but it is going to unfold differently. We have learned not to allow the financial market to collapse. We will spend all the money in the world to prevent that from happening.

SPIEGEL: Obama is supposed to save the banks, bail out the auto industry and boost the economy in general. Can a single person ever live up to such high expectations?

Soros: Perhaps not, but the problems can be handled much better than they have been by the current administration.

SPIEGEL: Currently, Treasury Secretary Henry Paulson is in charge of the bail-out. What are your misgivings about his performance?

Soros: He reacted to problems as they arose; he had no capacity to anticipate them. When he allowed Lehman Brothers to fail, the breakdown of the financial markets found him totally unprepared. He went to Congress not with a plan but with a plan to develop a plan. And the plan he had in mind -- to purchase toxic assets -- was ill-conceived. Injecting equity capital into the banking system made much more sense and he eventually came to see that, but again he went about it in the wrong way. Then he stopped doing anything, leaving a vacuum in leadership, and the markets collapsed.

SPIEGEL: What are your expectations for the next Secretary of the Treasury?

Soros: I think we need a large stimulus package which will provide funds for state and local government to maintain their budgets -- because they are not allowed by the constitution to run a deficit. For such a program to be successful, the federal government would need to provide hundreds of billions of dollars. In addition, another infrastructure program is necessary. In total, the cost would be in the 300 to 600 billion dollar range.

SPIEGEL: In addition to the $700 billion bailout for the financial industry?

DPA

Financial manager George Soros worries about a leadership vacuum during the transition from President George W. Bush to President-elect Barack Obama.

Soros: Definitely. I think this is a great opportunity to finally deal with global warming and energy dependence. The US needs a cap and trade system with auctioning of licenses for emissions rights. I would use the revenues from these auctions to launch a new, environmentally friendly energy policy. That would be yet another federal program that could help us to overcome the current stagnation.


SPIEGEL: Your proposal would be dismissed on Wall Street as "big government." Republicans might call it European-style "socialism."

Soros: That is exactly what we need now. I am against market fundamentalism. I think this propaganda that government involvement is always bad has been very successful -- but also very harmful to our society.

SPIEGEL: Would you advise the new president to say that publicly?

Soros: He has already spoken about changing the political discourse. I think it is better to have a government that wants to provide good government than a government that doesn't believe in government.

SPIEGEL: However, even a strong government can't perform miracles. It needs money from the taxpayers. There is a lot of talk in the US about the new role of the state and the government -- but no one seems to be willing to pay for it. Obama has announced to cut taxes for 95 percent of working Americans. Isn't that a contradiction?


"I Always Play by the Rules"
Soros: At times of recession, running a budget deficit is highly desirable. Once the economy begins to recover, you have to balance the budget. In 2010, the Bush tax cuts will expire and we should not extend them. But we will also need additional revenues. Should the government not receive them, we will all get punished with higher interest rates.

SPIEGEL: Everybody says we have to regulate the financial markets more. That sounds good, but is it realistic? Can one really tame the markets?

Soros: Between regulators and market participants, there is a cat and mouse game going on which has been going on indefinitely…

SPIEGEL: …where often the mice, the market participants, have the upper hand.

Soros: Because they got the extra boost from market fundamentalists. But the outcome was disastrous, as we see now. I think it is better to have a cat and mouse game where the cat has the upper hand than a cat and mouse game where the mice are ruling. Because the latter means that the market participants are given free range. That was actually the big misconception of our national hero Ronald Reagan, who always talked about the magic of the market.

SPIEGEL: So you support stricter regulation and more efficient control of the markets?

Soros: Indeed. However, you have to recognize that regulations will never be completely successful and they will always be full of holes. You must constantly be ready to fill new holes. Actually regulation should be kept to a minimum, but there has to be some cooperation between market participants and authorities -- as was the case in the early postwar years. The Bank of England was a very successful regulator by cooperating with market participants. This cooperative spirit was broken by the market fundamentalists.

SPIEGEL: Not in Germany. We have many semi-private banks that largely dominate the market. Politicians serve on their supervisory boards. But they are in particularly bad shape.

Soros: These public-private partnerships are very, very dangerous. The most rotten part of the financial system in the US consisted of the government sponsored entities, Fannie Mae and Freddie Mac. They really kicked off this crisis. The state should set the rules and enforce them -- but not become involved as a market player.

SPIEGEL: You are one of the most powerful speculators in the world and have been heavily involved in your fund's activities over the past few months. How do you cope with the dilemma of being a speculator -- who often profits from a business transaction that might hurt society?

Soros: This is a false issue. I always play by the rules. At the same time, I try to improve the rules. In so doing I often suggest changes from which I would not personally benefit. I have the common interest at heart, not my personal interest.

SPIEGEL: But the perception many people have of you and your colleagues is very different. They blame speculators for the current financial crisis -- is that the reason for your decision to give billions of dollars to charity and your foundation?

Soros: People think I am giving money because I have pangs of conscience.

SPIEGEL: Isn't there some truth to it?

Soros: No. It is a total misconception. The big events in which I participated would have occurred whether I took part in them or not. For example, whether I had been born or not, the British pound would have been forced out of the European Exchange Rate Mechanism in 1992.

SPIEGEL: But are you really such a little wheel as you claim? If you bet against grain, rice or oil, many other investors follow suit. That could hurt consumers who can no longer afford essential foodstuffs or energy. You can definitely influence markets.

Soros: Since I became a public figure, the man who allegedly "broke the Bank of England,” I have been cast as a financial guru who can influence markets. That has actually created more moral problems for me. It has forced me to impose certain self-constraints in my statements -- exactly because I can move markets, like the investor Warren Buffett. Therefore, we try to act very responsibly.

SPIEGEL: Does the world need hedge funds?

Soros: I think that hedge funds are a very efficient way of managing money. But I clearly see the risks. Hedge funds use credit and credit is a source of instability. My conclusion is that transactions involving credit should be regulated.

SPIEGEL: Now you sound like a person who runs to a police station and tells the officers: "Please, handcuff me -- I am dangerous!"

Soros: Not really. I think there needs to be appropriate regulation of the financial markets, but it is impossible to prevent speculation. There is very little difference between speculation and investment. The only difference is basically that investments are successful speculations because if you successfully anticipate the future you make a speculative profit. I don't have a bad conscience at all. I am very proud to be a successful speculator.

SPIEGEL: Average citizens are not much impressed. They no longer trust Wall Street.

Soros: That mistrust is well placed. Those very prestigious institutions on Wall Street pursue their self-interest, and that is not identical to the common interest -- which needs to be protected.

SPIEGEL: Many people also no longer have confidence in the bailout measures taken by the Bush administration. Some critics claim that Treasury Secretary Henry Paulson is simply trying to bail out his former colleagues on Wall Street. Paulson was once the CEO of Goldman Sachs.

Soros: That may be going too far. But it is true that Paulson sees the problems too much from the perspective of a Wall Street banker.

SPIEGEL: He is also reluctant to push for salary caps for CEOs or bonus restrictions at banks receiving government aid.

Soros: Giving government aid to a bank basically transforms it into a utility. The huge salaries in this sector are only a symptom of a more profound misalignment. The profitability of the finance industry has been excessive. For a while, 35 percent of all corporate profits in the UK and the US came from the financial sector. That was absurd.

SPIEGEL: We talked a lot about the losers of the current financial disaster. Do you also see winners?

Soros: China could easily emerge as the great winner if the Chinese leaders handle the situation well. On the other hand, they could also turn out to be the biggest losers if they handle it poorly. If the management turns out be wrong, this could lead to a political crisis in China. It's still too early to declare winners and losers.

SPIEGEL: Could Obama be the first "post-American president" -- because his country loses economic force and "soft power"?

Soros: If Obama is wise, he will find common ground with China to solve this crisis. If he wants to do it alone, we will go into a worldwide depression because America is not in a position by itself to clean up the mess it created.

SPIEGEL: Mr. Soros, thank you very much for this conversation.

The Crisis & What to Do About It

By George Soros
1.

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. To understand what has happened, and what should be done to avoid such a catastrophic crisis in the future, will require a new way of thinking about how markets work.

Consider how the crisis has unfolded over the past eighteen months. The proximate cause is to be found in the housing bubble or more exactly in the excesses of the subprime mortgage market. The longer a double-digit rise in house prices lasted, the more lax the lending practices became. In the end, people could borrow 100 percent of inflated house prices with no money down. Insiders referred to subprime loans as ninja loans—no income, no job, no questions asked.

The excesses became evident after house prices peaked in 2006 and subprime mortgage lenders began declaring bankruptcy around March 2007. The problems reached crisis proportions in August 2007. The Federal Reserve and other financial authorities had believed that the subprime crisis was an isolated phenomenon that might cause losses of around $100 billion. Instead, the crisis spread with amazing rapidity to other markets. Some highly leveraged hedge funds collapsed and some lightly regulated financial institutions, notably the largest mortgage originator in the US, Countrywide Financial, had to be acquired by other institutions in order to survive.


Confidence in the creditworthiness of many financial institutions was shaken and interbank lending was disrupted. In quick succession, a variety of esoteric credit markets—ranging from collateralized debt obligations (CDOs) to auction-rated municipal bonds—broke down one after another. After periods of relative calm and partial recovery, crisis episodes recurred in January 2008, precipitated by a rogue trader at Société Générale; in March, associated with the demise of Bear Stearns; and then in July, when IndyMac Bank, the largest savings bank in the Los Angeles area, went into receivership, becoming the fourth-largest bank failure in US history. The deepest fall of all came in September, caused by the disorderly bankruptcy of Lehman Brothers in which holders of commercial paper—for example, short-term, unsecured promissory notes—issued by Lehman lost their money.

hen the inconceivable occurred: the financial system actually melted down. A large money market fund that had invested in commercial paper issued by Lehman Brothers "broke the buck," i.e., its asset value fell below the dollar amount deposited, breaking an implicit promise that deposits in such funds are totally safe and liquid. This started a run on money market funds and the funds stopped buying commercial paper. Since they were the largest buyers, the commercial paper market ceased to function. The issuers of commercial paper were forced to draw down their credit lines, bringing interbank lending to a standstill. Credit spreads—i.e., the risk premium over and above the riskless rate of interest—widened to unprecedented levels and eventually the stock market was also overwhelmed by panic. All this happened in the space of a week.

With the financial system in cardiac arrest, resuscitating it took precedence over considerations of moral hazard—i.e., the danger that coming to the rescue of a financial institution in difficulties would reward and encourage reckless behavior in the future—and the authorities injected ever larger quantities of money. The balance sheet of the Federal Reserve ballooned from $800 billion to $1,800 billion in a couple of weeks. When that was not enough, the American and European financial authorities committed themselves not to allow any other major financial institution to fail.

These unprecedented measures have begun to have an effect: interbank lending has resumed and the London Interbank Offered Rate (LIBOR) has improved. The financial crisis has shown signs of abating. But guaranteeing that the banks at the center of the global financial system will not fail has precipitated a new crisis that caught the authorities unawares: countries at the periphery, whether in Eastern Europe, Asia, or Latin America, could not offer similarly credible guarantees, and financial capital started fleeing from the periphery to the center. All currencies fell against the dollar and the yen, some of them precipitously. Commodity prices dropped like a stone and interest rates in emerging markets soared. So did premiums on insurance against credit default. Hedge funds and other leveraged investors suffered enormous losses, precipitating margin calls and forced selling that have also spread to markets at the center.

Unfortunately the authorities are always lagging behind events. The International Monetary Fund is establishing a new credit facility that allows financially sound periphery countries to borrow without any conditions up to five times their annual quota, but that is too little too late. A much larger pool of money is needed to reassure markets. And if the top tier of periphery countries is saved, what happens to the lower-tier countries? The race to save the international financial system is still ongoing. Even if it is successful, consumers, investors, and businesses are undergoing a traumatic experience whose full impact on global economic activity is yet to be felt. A deep recession is now inevitable and the possibility of a depression cannot be ruled out. When I predicted earlier this year that we were facing the worst financial crisis since the 1930s, I did not anticipate that conditions would deteriorate so badly.

2.

This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

While the two-way connection is present at all times, it is only occasionally, and in special circumstances, that it gives rise to financial crises. Usually markets correct their own mistakes, but occasionally there is a misconception or misinterpretation that finds a way to reinforce a trend that is already present in reality and by doing so it also reinforces itself. Such self- reinforcing processes may carry markets into far-from-equilibrium territory. Unless something happens to abort the reflexive interaction sooner, it may persist until the misconception becomes so glaring that it has to be recognized as such. When that happens the trend becomes unsustainable and when it is reversed the self-reinforcing process starts working in the opposite direction, causing a sharp downward movement.

The typical sequence of boom and bust has an asymmetric shape. The boom develops slowly and accelerates gradually. The bust, when it occurs, tends to be short and sharp. The asymmetry is due to the role that credit plays. As prices rise, the same collateral can support a greater amount of credit. Rising prices also tend to generate optimism and encourage a greater use of leverage—borrowing for investment purposes. At the peak of the boom both the value of the collateral and the degree of leverage reach a peak. When the price trend is reversed participants are vulnerable to margin calls and, as we've seen in 2008, the forced liquidation of collateral leads to a catastrophic acceleration on the downside.

Bubbles thus have two components: a trend that prevails in reality and a misconception relating to that trend. The simplest and most common example is to be found in real estate. The trend consists of an increased willingness to lend and a rise in prices. The misconception is that the value of the real estate is independent of the willingness to lend. That misconception encourages bankers to become more lax in their lending practices as prices rise and defaults on mortgage payments diminish. That is how real estate bubbles, including the recent housing bubble, are born. It is remarkable how the misconception continues to recur in various guises in spite of a long history of real estate bubbles bursting.

Bubbles are not the only manifestations of reflexivity in financial markets, but they are the most spectacular. Bubbles always involve the expansion and contraction of credit and they tend to have catastrophic consequences. Since financial markets are prone to produce bubbles and bubbles cause trouble, financial markets have become regulated by the financial authorities. In the United States they include the Federal Reserve, the Treasury, the Securities and Exchange Commission, and many other agencies.

It is important to recognize that regulators base their decisions on a distorted view of reality just as much as market participants—perhaps even more so because regulators are not only human but also bureaucratic and subject to political influences. So the interplay between regulators and market participants is also reflexive in character. In contrast to bubbles, which occur only infrequently, the cat-and-mouse game between regulators and markets goes on continuously. As a consequence reflexivity is at work at all times and it is a mistake to ignore its influence. Yet that is exactly what the prevailing theory of financial markets has done and that mistake is ultimately responsible for the severity of the current crisis.

3.

In my book The New Paradigm for Financial Markets,<*> I argue that the current crisis differs from the various financial crises that preceded it. I base that assertion on the hypothesis that the explosion of the US housing bubble acted as the detonator for a much larger "super-bubble" that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit—whether extended to consumers or speculators or banks—has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom.

The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect.

Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences. Indeed, we have experienced a series of financial crises since then, but the adverse consequences were suffered principally by the countries that lie on the periphery of the global financial system, not by those at the center. The system is under the control of the developed countries, especially the United States, which enjoys veto rights in the International Monetary Fund.

Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices.

It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006. Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. They ought to have known better since it was their actions that kept the United States economy on an even keel. Alan Greenspan, in particular, believed that giving users of financial innovations such as derivatives free rein brought such great benefits that having to clean up behind the occasional financial mishap was a small price to pay. And his analysis of the costs and benefits of his permissive policies was not totally wrong while the super-bubble lasted. Only now has he been forced to acknowledge that there was a flaw in his argument.

Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and "managing" risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion. But the increased use of financial engineering set in motion a process of boom and bust. So eventually there was hell to pay. At first the occasional financial crises served as successful tests. But the subprime crisis came to play a different role: it served as the culmination or reversal point of the super-bubble.

It should be emphasized that this interpretation of the current situation does not necessarily follow from my model of boom and bust. Had the financial authorities succeeded in containing the subprime crisis—as they thought at the time they would be able to do—this would have been seen as just another successful test instead of the reversal point. I have cried wolf three times: first with The Alchemy of Finance in 1987, then with The Crisis of Global Capitalism in 1998, and now. Only now did the wolf arrive.

My interpretation of financial markets based on reflexivity can explain events better than it can predict them. It is less ambitious than the previous theory. It does not claim to determine the outcome as equilibrium theory does. It can assert that a boom must eventually lead to a bust, but it cannot determine either the extent or the duration of a boom. Indeed, those of us who recognized that there was a housing bubble expected it to burst much sooner. Had it done so, the damage would have been much smaller and the super-bubble may have remained intact. Most of the damage was caused by mortgage-related securities issued in the last two years of the housing boom.

The fact that the new paradigm does not claim to predict the future explains why it did not make any headway until now, but in the light of recent experience it can no longer be ignored. We must come to terms with the fact that reflexivity introduces an element of uncertainty into financial markets that the previous theory left out of account. That theory was used to establish mathematical models for calculating risk and converting bundles of subprime mortgages into tradable securities, as well as other forms of debt. Uncertainty by definition cannot be quantified. Excessive reliance on those mathematical models did untold harm.

4.

The new paradigm has far-reaching implications for the regulation of financial markets. Since they are prone to create asset bubbles, regulators such as the Fed, the Treasury, and the SEC must accept responsibility for preventing bubbles from growing too big. Until now financial authorities have explicitly rejected that responsibility.

It is impossible to prevent bubbles from forming, but it should be possible to keep them within tolerable bounds. It cannot be done by controlling only the money supply. Regulators must also take into account credit conditions because money and credit do not move in lockstep. Markets have moods and biases and it falls to regulators to counterbalance them. That requires the use of judgment and since regulators are also human, they are bound to make mistakes. They have the advantage, however, of getting feedback from the market and that should enable them to correct their mistakes. If a tightening of margin and minimum capital requirements does not deflate a bubble, they can tighten them some more. But the process is not foolproof because markets can also be wrong. The search for the optimum equilibrium has to be a never-ending process of trial and error.

The cat-and-mouse game between regulators and market participants is already ongoing, but its true nature has not yet been acknowledged. Alan Greenspan was a past master of manipulation with his Delphic utterances, but instead of acknowledging what he was doing he pretended that he was merely a passive observer of the facts. Reflexivity remained a state secret. That is why the super-bubble could develop so far during his tenure.

Since money and credit do not move in lockstep and asset bubbles cannot be controlled purely by monetary means, additional tools must be employed, or more accurately reactivated, since they were in active use in the 1950s and 1960s. I refer to variable margin requirements and minimal capital requirements, which are meant to control the amount of leverage market participants can employ. Central banks even used to issue guidance to banks about how they should allocate loans to specific sectors of the economy. Such directives may be preferable to the blunt instruments of monetary policy in combating "irrational exuberance" in particular sectors, such as information technology or real estate.

Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used. Such regulation should be a high priority of the new Obama administration. It is all the more necessary because financial engineering often aims at circumventing regulations.

Take for example credit default swaps (CDSs), instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.

Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.

In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.