Thursday, February 10, 2011

George Soros and Avoiding the Next Financial Crisis

Bloomberg reported on George Soros' diagnosis of the cause of the financial crisis, [emphasis added]
Billionaire George Soros said the financial crisis was avoidable and was caused by market participants and regulators following flawed market theories. 
It’s the theories adopted by both the regulators and the market participants that proved to be false,” Soros, 80, said in an October 2010 interview released today by the Financial Crisis Inquiry Commission on its website. “It’s the efficient- market hypothesis and the rational expectations theory.” 
The efficient-market hypothesis holds that prices reflect all relevant information available to market participants. Under the rational expectations theory, people make decisions based on their rational outlook while influenced by past experiences.
Your humble blogger agrees that the financial crisis was avoidable, but disagrees with Mr. Soros that it was the theories that were flawed and caused the financial crisis.

Why?

The efficient market hypothesis makes an assumption about the ability of market participants to access all the relevant facts to make a fully informed decision. 

The Financial Crisis Inquiry Commission report documents that market participants did not have access to all the relevant facts before or during the financial crisis.

It was the lack of relevant facts that was the driver behind contagion.  It was the single sufficient and necessary condition for the old fashion 'run on the banks' that the financial system experienced.

First, the financial markets had to guess at Bear Stearns solvency.

Why did they have to guess?

The Brown Paper Bag Challenge demonstrates that investors did [and still do] not have access to all the relevant facts to value a structured finance security or a financial institution.

This was a fact known to investors.  After all,  they referred to structured finance securities as opaque, toxic securities.

The investors also knew that Bear had an exposure to structured finance securities that was well in excess of its capital.  What the investors did not know was whether the value of Bear's assets exceeded the value of its liabilities.  The need for government assistance to take on structured finance securities in JP Morgan's purchase of Bear confirmed that Bear was not solvent.

The fact that market participants acted as rational expectations predicted is what caused the credit markets to freeze.

The financial markets also had to guess at Lehman Brothers solvency.

Why did the markets have to guess?

The investors knew that Lehman had an exposure to structured finance securities and real estate that was well in excess of its capital.  What the investors did not know was whether the value of Lehman's assets exceeded the value of its liabilities.

In addition, the financial market expected that the government would step in and stop Lehman Brothers from going bankrupt. This was exactly as expected by the rational expectation hypothesis given the Bear experience.

After the government did not step in and prevent Lehman Brothers from going bankrupt and the Reserve Fund from breaking the buck, investors and lenders realized their money was at risk.

Since it was not insured in the money market funds which purchased commercial paper, they raced in an old fashion bank run to get it out before they would lose it.

Banks also realized their money was at risk and contributed to the old fashion bank run by behaving as rational expectations would predict.  Banks stopped lending to other financial institutions where they had to guess if the financial institution was solvent or not based on that financial institution's holdings of opaque, toxic assets.

The solution is not to devise new theories.


Rather it is for government to recognize its responsibilities under the FDR Framework and ensure that genuine transparency in the form of all the useful, relevant data in an appropriate, timely manner is made available to all market participants.

To this end, the Economist Magazine and your humble blogger have called for using 21st century information technology to create the 'Mother of All Databases'.  This database will have the current asset-level data on an observable event basis that market participants need to be able to access for all the relevant facts.

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