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Soros - There is a fundamental market misconception (it says so in my book)

Market fundamentalists (otherwise known as financial authorities and institutions) believe in a tendency toward equilibrium. However, says Soros’ column in Thursday’s FT, this belief in the market’s supposedly random deviations from equilibrium and it’s ability to self correct is basically false.

It is the boom-bust sequence that characterises the market. Soros notes that regulation is not the key, as it can only ever respond after the fact. Authorities need to point their gaze toward the next issue that will arise, CDS and mortgage defaults. Soros suggests that credit default swap contracts could be submitted through a clearing house or exchange with a sound capital structure. For mortgages the bankruptcy laws could be adjusted to allow for mortgage terms to be modified. Another suggestion “would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value”.

Making the media rounds, Soros commented to Bloomberg that this is the worst financial crisis since the great depression. In a moodily lit interview with Robert Peston, Soros suggests that current market turmoil is in fact the result of the demise of one of the biggest bubbles - the WW2 bubble that resulted in the long term increase in the use of leverage. There are asymmetric incentives, leveraging is encouraged, but when a crisis occurs, authorities intervene.

In his Bloomberg interview Soros says that he expects the markets to fall more this year, with the current rebound lasting no more than three months.

Soros has bet on declines in the dollar, 10-year Treasuries and U.S. and European stocks. He expected foreign currencies to rise, as well as Chinese and Indian equities. The latter bet helped Quantum return 32 percent in 2007.

This entry was posted by Alida Smith on Thursday, April 3rd, 2008 at 9:00 and is filed under Capital markets, People. Tagged with . You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. Apr 07   1:18 Posted by M Nevin [report]

    Soros suggests that credit default swap contracts could be submitted through a clearing house or exchange with a sound capital structure.
    But insurance, or its insufficiency, was the problem. These instruments grew in so many directions that insurers were swamped. What clearing entity will be able to take the other side of these deals in order to clear them? It’s fine when things are chugging along, but when the market teeters, the depths are too far a stretch for counterparties to handle. The proof is that Wall St. had to resort to the Fed to take that role.
    You know when we’ll know it’s safe to go back in the water? When Wall St. admits it made mistakes and explains those mistakes. So far the biggest, brightest houses are hiding behind Joe Sixpack’s bad mortgage. But those mortgages are just one of myriad risks quants are supposed to take into account everyday in designing and forecasting the behavior of these instruments. Of course, the stories are also starting to trickle out from the designers themselves about how their inventions became misused and abused. My money is on the quants having done their jobs. Until Wall St. owns up to how and when it miscalculated no one should feel safe.

  2. Apr 04   5:46 Posted by D Merkel [report]

    Much as I think Soros is a bright guy (check out the book reviews at my blog), he is wrong here. Derivatives are different than stocks or options, in many ways they are more akin to bonds. Bonds don’t trade over exchanges, because they trade in chunks, and there are too many of them. Also, most derivatives involve payment over time, and uncertain payment at maturity/event horizon. This means that there is credit involved in any transaction, which creates the complications that exchanges are not meant to deal with.

  3. Apr 03   23:00 Posted by TED [report]

    Last year we learned to say subprime. This year we will learn about counterparty risk.

    http://www.eurointelligence.com/article.581 M55054ba986e.0.html

  4. Apr 03   22:25 Posted by Anonymous [report]

    CDS Explained: Relax (not) and listen to Prof Michael Greenberger (ex head of the Commodities Future Trading Corp on NPR

    http://www.npr.org/templates/story/story.php?storyId=89338743

  5. Apr 03   13:40 Posted by fugger [report]

    Re ‘the authorities ought to prepare for the next shoes to drop..There is an esoteric financial instrument called the credit default swap..’ CDSs are only esoteric to out-of-touch retired people like Soros and that other self-important talking head John Moulton. So bored with people making ‘we’re all doomed’ comments about the CDS market. CDS are just another OTC derivative - an instrument not a risk. Counterparties would be in trouble if a big dealer defaulted - but no more than on all their other OTC derivative contracts. And most CDS exposures, like those on other derivatives, are collateralised. The big exceptions were the monolines, which never gave collateral. Other than that, CDS are just a mechanism for reshuffling losses around the system following a corporate default. And a very useful mechanism - the CDS indices are about the only liquid credit instrument left.

  6. Apr 03   9:23 Posted by Lemmy [report]

    Mortgage defaults and overshooting resi property price falls shouldn’t come as a surprise. We know the CDS market hasn’t been tested in a downturn either. Is it only when headwinds appear that people start asking questions about mortgage defaults and the resilience of the CDS market?
    Regulation and policy responses create opportunities for investors: for example today’s rate cut could bring tomorrow’s inflation; new bank regulation will create more loopholes and other unintended consequences. These are the bread and butter of which Soros and his colleagues have often profited and why Soros is, for me, an interesting mind.

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