Soros' point of view

Recently, I got accross through a friend a very interesting article from George Soros' webpage. It deals with the causes of the financial crisis. Here I present some extracts from it together with some comments.

The article is very interesting and touches to start with with the reason for the crisis that we have all heard already:

"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."

We tend to believe that if regulators let the system be, it must be ok, but as Soros says,

"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"

The point I wanted to stress, though, is the effect that has had on the crisis the absolute ignorance of banks when it came to calculate the risks of some of the products they sell:

"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."

Anyone working in investment banks can tell you that the fact that regulators trusted the risk models from the banks is the real problem. Some of the risk models that banks had (have!) for credit products are a joke. You get 20-year-olds managing millions in risk they don't even understand. It all boils down, I must say, to very simplistic models in the first place (quants!). It is the need to produce new models as fast as you can that leads to innacuracies. Again, the hurry coming from the ever present greed.

About this problem of all-too-complex products, Soros says

"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."

But the problem is, in my opinion, that you can never be sure that the regulator knows what he is doing! How do we know that they understand the products. I believe there should be a limit in the leverage products can offer (leverage = potential gains vs initial investment), because the higher the leverage, the higher the inherent risk and potential damage. Actually, Soros points this out as well at the end:

"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."

Of course, that would make banks less profitable and, therefore, limit the speed to which management can get rich, which is a good thing. However, that's certainly not the panacea we are looking for, and one feels that something of a greater magnitude is necessary. A full change in the financial systems, which may be even too much to take for the leaders of our world, including Mr Obama.


The trader's point of view

Following on my last post on the G20 protests, I thought it would be fair enough to give a chance to a trader's opinion on the whole economic world crisis. I had at work a very interesting conversation with some of my trader colleagues. When I asked them if they still believed that a pure, crude, free non-intervention capitalist market is the way to go they did not hesitate for a moment: yes.

I raised my eyebrow. 'Really?', I asked. They were outraged by how the governments are not only not taking more responsibility for what has happened, but also actually blaming the greed of the bankers for it. As they put it, this is a very naive way of shifting the anger of the public toward them (us, should I say).

For them, the reasons for this crisis is clear: the non-inclusion of the house prices in the inflation index, the CPI (Consumer Price Index). Let me explain: the only tool for intervention that governments have to control the markets and the overall economy are the interest rates. The interest rates are the rates that banks need to pay to borrow money from the Bank of England overnight to cover their daily mismatches. Banks borrow money from each other as well, at a rate that is slightly higher than the interest rate set by the BoE (for the added risk that banks can potentially default). Ultimately, the interest rates will determine (in a normal market) the mortgage rates citizens pay to the banks when they buy a house.

The other thing to understand is which rules does the BoE follow to change the interest rates. The main aim of the BoE is to maintain inflation under control, so prices are stable. The inflation is measured with the CPI, which is a basket of prices of several products, such as food, transport, fuel... Indeed, in the BoE website, we can read the quote The Bank sets interest rates to keep inflation low, issues banknotes and works to maintain a stable financial system.

So, in a nutshell, the BoE looks at inflation and changes rates accordingly, determining how much do we pay for our mortgages and, therefore, controlling how much money we have at the end of the month to spend in other things (clothes, food, shoes, holidays...). The less money we have, the less we spend, stopping prices from increasing. And vice versa. So if inflation increases, the BoE increases rates, and vice versa.

Now, once we understand that, does it make sense to anyone that house prices are not included in the CPI? Think about it: for years, the CPI index was under perfect control, while house prices were increasing at alarming rates (15%-20% a year for the past 5 years or so). Narrowmindedly, the BoE found no reason to increase rates because the CPI was within target, while the housing bubble was growing. Even if rates were not quite low, people found it easy to get massive mortgages, without stopping to think that they were paying stupidly high prices for their houses. Banks were happy to give money away because as long as house prices were going up, they would make a profit from reposessions as well.

And we all know the rest of the story: when the bubble burst, everybody was caught in underpants, and now the BoE rushes to lower rates (we are at 0.5% now) to get us to spend again. The point of my colleagues was that had the house prices been in the CPI calculation, inflation would have raised above target as soon as house prices would have started to go up, triggering the BoE's reaction of increasing rates much earlier and potentially stopping the housing bubble that eventually started it all in the US.

This is not to say that free capitalism is still the way to go, certainly not in my opinion. I believe that in the same sense that we have laws to control other human impulses, we should try and do our best to control greed, because it damages society ultimately. But it does tells us that most of us don't know near as much as we should before drawing hasty conclusions condemning bankers as full responsible for this situation.

I believe it is positive and legitimate to go and protest against capitalism as we know it (indeed, other socioeconomical systems are possible), but it may not be a bad idea to get out there again asking for a fair inclusion of house prices into the CPI: it is simply reasonable.