George Soros has a very interesting opinion piece in the Financial Times, June 17, 2009 (might be behind subscriber wall at the FT, but I received it by email from his office, so I’ll quote some bits from there). The essay outlines in short form his principles for reform of financial regulation. I am still absorbing this, so I won’t comment here, but I put them out for your thoughts. I will try to post up some other stuff on the financial regulation reform proposals coming from the Obama administration over the next couple of days. (As ever, however, I am always eager to learn from what co-blogger Zywicki has to say about this stuff, and particularly the bankruptcy questions of Chrysler, GM, and Delphi – I am no expert by any stretch on sale v reorganization, or anything else, re bankruptcy. See Todd’s earlier post comparing Chrysler, GM and the secured creditor treatment in each.)
So, Soros starts out with a general comment on the comparative disadvantages of un-regulation and government regulators:
I am not an advocate of too much regulation. Having gone too far in deregulating – which contributed to the current crisis – we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum.
He then goes on to propose three guiding principles for regulatory reform. The first is that regulators must accept responsibility for not allowing bubbles to get out of control. This is framed within the inherent contradiction, Soros suggests, that regulators are no better than markets at identifying what’s a bubble and what’s not.
[S]ince markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually re-calibrate to correct their mistakes.
The implicit assumption here – correct, in my view – is that we have a problem of too-big-to-fail in these bubbles, systemic risk, and the loss of the threat of moral hazard: the Greenspan and next the Bernanke put. It is therefore not a sufficient answer for regulators to refuse to take on the burden of bubble-popping. This seems to me quite persuasive.
Second, Soros goes on, the problem is not merely the money supply, though that is a factor, it is also the availability of credit and then leverage off of it:
Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone – we must also use credit controls such as margin requirements and minimum capital requirements. Currently these tend to be fixed irrespective of the market’s mood. Part of the authorities’ job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.
Again, I think this is broadly persuasive. I say this despite being a big fan of John Taylor’s new, short book from the Hoover Institution Press, Getting Off Track. The strong version of Taylor’s argument, Steve Krasner noted to me in conversation last week at Stanford, is that if the Fed had simply followed the Taylor rule regarding the money supply, then the bubble would not have developed. On the strong version of Taylor’s argument in the book, whatever the failures of regulation or, responding to Greenspan’s reply to Taylor, the global savings glut, it doesn’t matter – the money supply was the problem. Soros is implicitly saying that money supply alone is not the issue; credit and leverage matter on their own, and so does regulation directly going to credit, e.g., margin and capital requirements. Again, I am a big fan of Taylor’s book – but I am content to read the argument more weakly, so to understand that the crisis is overdetermined, and that money supply, credit and leverage, political temptations in regulation, etc., all play a role. I think most financial commentators would go with the weaker position of overdetermination of causes. And on the credit question – more precisely, the leverage question – Soros is right, I think.
Soros finally – third – says that financial regulation must take up the question of efficient market theory. On this, he is most controversial. He has addressed much criticism toward the EMH over the years – and the arguments are not always the same, nor of the same level of breadth or generality. On the one hand, the latest edition of Bratton’s Corporate Finance textbook, which I am about to use in the Fall semester for the first time in a couple of years and which begins with a discussion of efficient markets, expresses much greater caution, consistent with most academic commentators. Certainly that is my feeling, particularly with regard to credit markets and instruments. On the other hand, I was dismayed by how thoroughly my law students last year dismissed market efficiency as having any value at all and the very idea of quantitative valuation (of course, this would save them the trouble of doing the present value arithmetic …). So what is Soros’s formulation of the critique of EMH and how conceptually global is it in this iteration?
Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.
But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.
The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.
The critique of efficient market theory here is agent-failure. No argument there – the agency problems go deep into the heart of the financial services institutions themselves, to include the fundamental problem of what Steve Schwarcz has described as secondary agent failures – misalignments of both duty of care and duty of loyalty. AT bottom, Soros is pointing to information uncertainties in two directions: one, as between managers and financial agents and, two, between compensation in the present on uncertain future payoffs, without an effective mechanism of clawback to correct results after the fact or an effective discounting mechanism to address potential future failure. But at bottom the critique in this piece of EMH is an agent-principal critique. One can add other critiques; some stronger and some weaker, but Soros has identified the one most amenable to regulatory reform, I reckon.
Given the agent-centered critique, it is no surprise that Soros favors a “skin in the game” approach – and he says that the 5% retention by originators in securitizations is too small:
To avert a repetition, the agents must have “skin in the game” but the five per cent proposed by the administration is more symbolic than substantive. I would consider ten per cent as the minimum requirement. To allow for possible discontinuities in markets securities held by banks should carry a higher risk rating than they do under the Basel Accords. Banks should pay for the implicit guarantee they enjoy by using less leverage and accepting restrictions on how they invest depositors’ money; they should not be allowed to speculate for their own account with other people’s money.
It is probably impractical to separate investment banking from commercial banking as the US did with the Glass Steagull Act of 1933. But there has to be an internal firewall that separates proprietary trading from commercial banking. Proprietary trading ought to be financed out of a bank’s own capital. If a bank is too big to fail, regulators must go even further to protect its capital from undue risk. They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned. This may push proprietary trading out of banks into hedge funds. That is where it properly belongs.
Again, little argument from me that proprietary trading conceptually at least belongs in the hedge funds and private equity funds, whether that is practical today or not. Proprietary trading is not the only problem. I ordinarily teach a private equity course each year; it covers the industry as a whole, including venture capital, buy out funds of various kinds, etc., and I throw in little bit on hedge funds as they aren’t really covered elsewhere in our curriculum. But I was troubled when last I taught the class in spring 2008 at a quote in a Henry Kaufmann article in the WSJ – I always talked as an academic about private equity serving to bring managerial efficiencies to public companies via buyouts and all sorts of jolly stuff. Whereas Kaufmann quoted a LBO fund manager as shrugging and saying, in paraphrase, we’re just part of the big mechanism that takes money from the Fed and pours it into the housing markets and take a cut along the way. Ouch, ouch, double ouch.
And finally … derivatives. Do not fail to note Soros’s blunt comment on credit default swaps (italics added below). I am not sure I would have focused on CDSs, once having put them onto public exchanges and regularized and made public the counterparty relationships. Nor do I think that the underlying securitizations are themselves the problem. I grant the agency issues that Soros raises and of course there is a huge, huge problem with insurance that turns out to be a license to kill. The problem is more than just license to kill. It is also what we might call a “license to be indifferent” – arising from what has been talked about as the “phantom” creditor problem – formally holding debt the risks of which have already, but non-publicly or transparently, been counter-partied away, leaving one with an incentive to indifference or something more toxic. Moreover, the mere existence of an insurance market in CDSs does not, by itself alone, solve the valuation problem of the underlying assets or the insurance. Still, I think I probably would have instead focused on the derivatives built to leverage the securitizations themselves as being the most dangerous and toxic assets in all of this:
Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent.
Custom made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and thatof General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.
Whether one agrees with Soros on each item, or the strength he assigns each item, this is an outstanding short essay on reform agendas. As I remarked in my note on the passing of Peter Bernstein, Soros on these issues of finance and political finance is in a category of senior, seasoned observer who is both at home with the analysis of risk but also very clear as to its limits, and rooted in the practical world of markets first and theory second. You can, as I do, think that Soros’s funding for things like Moveon.org and other bitterly partisan political ventures a very bad thing – and I mean a very bad thing, and a very bad thing including for the Democratic Party, but that’s a whole different discussion – while seeing the value in this kind of informed intervention. The financial crisis is a matter, unlike a range of others, that fits Soros’s very considerable public talents hand to glove.