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George Soros’s Game Changer. CDS market effects 101.

By George Soros
Published by Financial Times

In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences.

For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

How could Lehman have been left to go under? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve. The claim that they lacked the necessary legal powers is a lame excuse. In an emergency they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is, they allowed it to happen.

On a deeper level, too, credit default swaps played a critical role in Lehman’s demise. My explanation is controversial and all three steps of my argument will take the reader to unfamiliar ground.

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.

No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.

That is what AIG, one of the most successful insurance companies in the world, failed to understand. Its business was selling insurance and, when it saw a seriously mispriced risk, it went to town insuring it, in the belief that diversifying risk reduces it. It expected to make a fortune in the long run but it was destroyed in short order.

My argument raises some interesting questions. What would have happened if the uptick rule on shorting shares had been kept, in effect, but “naked” short-selling (where the vendor has not borrowed the stock in advance) and speculating in CDS had both been outlawed? The bankruptcy of Lehman might have been avoided but what would have happened to the asset super-bubble? One can only conjecture. My guess is that the bubble would have been deflated more slowly, with less catastrophic results, but that the after-effects would have lingered longer. It would have resembled more the Japanese experience than what is happening now.

What is the proper role of shortselling? Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. As bear raids can be self-validating, they ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for imposing no constraints. As it is, both the uptick rule and allowing short-selling only when it is covered by borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification.

What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but – in light of their asymmetric character – not to speculate against countries or companies.

CDS are not, however, the only synthetic financial instruments that have proved toxic. The same applies to the slicing and dicing of collateralised debt obligations and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have done a lot of damage. The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.

Now that the bankruptcy of Lehman has had the same shock effect on the behaviour of consumers and businesses as the bank failures of the 1930s, the problems facing the administration of President Barack Obama are even greater than those that confronted Franklin D. Roosevelt. Total credit outstanding was 160 per cent of gross domestic product in 1929 and rose to 260 per cent in 1932; we entered the crash of 2008 at 365 per cent and the ratio is bound to rise to 500 per cent. This is without taking into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. On the positive side, we have the experience of the 1930s and the prescriptions of John Maynard Keynes to draw on.

The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.

It can be done – by creating money to offset the contraction of credit, recapitalising the banking system and writing off or down the accumulated debt in an orderly manner. They require radical and unorthodox policy measures. For best results, the three processes should be combined.

If these measures were successful and credit started to expand, deflationary pressures would be replaced by the spectre of inflation and the authorities would have to drain the excess money supply from the economy almost as fast as they had pumped it in. There is no way to escape from a far-fromequilibrium situation – global deflation and depression – except by first inducing its opposite and then reducing it.

To prevent the US economy from sliding into a depression, Mr Obama must implement a radical and comprehensive set of policies. Alongside the welladvanced fiscal stimulus package, these should include a system-wide and compulsory recapitalisation of the banking system and a thorough overhaul of the mortgage system – reducing the cost of mortgages and foreclosures.

Energy policy could also play an important role in counteracting both depression and deflation. The American consumer can no longer act as the motor of the global economy. Alternative energy and developments that produce energy savings could serve as a new motor, but only if the price of conventional fuels is kept high enough to justify investing in those activities. That would involve putting a floor under the price of fossil fuels by imposing a price on carbon emissions and import duties on oil to keep the domestic price above, say, $70 per barrel.

Finally, the international financial system must be reformed. Far from providing a level playing field, the current system favours the countries in control of the international financial institutions, notably the US, to the detriment of nations at the periphery. The periphery countries have been subject to the market discipline dictated by the Washington consensus but the US was exempt from it.

How unfair the system is has been revealed by a crisis that originated in the US yet is doing more damage to the periphery. Assistance is needed to protect the financial systems of periphery countries, including trade finance, something that will require large contingency funds available at little notice for brief periods of time. Periphery governments will also need long-term financing to enable them to engage in counter-cyclical fiscal policies.

In addition, banking regulations need to be internationally co-ordinated. Market regulations should be global as well. National governments also need to co-ordinate their macroeconomic policies in order to avoid wide currency swings and other disruption.

This is a condensed, almost shorthand account of what needs to be done to turn the global economy around. It should give a sense of how difficult a task it is.

“A Colossal Failure Of Common Sense – The Inside Story Of The Collapse Of Lehman Brothers.” Published July 2009.

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Financial Crisis Explained – The Asparagus Connection

By Lawrence G. McDonald

The asparagus, in my opinion, is closely connected to the world economy falling to its knees.

Outside San Francisco, running east, are miles of farms, with acres of these green spears. It’s a Mecca for them. The weather is perfect, sun everyday, never too hot, never too cold.

Bliss.

And the place to live is downtown ‘Frisco, close to the many world-class restaurants and funky bars that have sweeping views of the Pacific, where you can watch long rollers crashing onto the endless shore.

The year is 2003, and the economy is shaken by scandal on Wall Street. Tyco, Adelphia and Worldcom have recently imploded, Jeff Skilling is front page news, and the women of Enron are in Playboy magazine. Corporate America is in disgrace, and news of greed and swindle are rife.

But this is America, the richest nation on earth. Nothing can destroy it. Plus the fact, Greenspan in charge, and he’s a genius. Also, the Sarbanes-Oxley Act was recently introduced – a law that states the head of any corporation, along with the chief financial officer, both have to sign the quarterly financial statements from now on, stating they’re true. If they turn out to be fraudulent, they both go to jail. That should put a nice end to cooking the books.

Then Alan Greenspan decided to keep rates low… like 1% low to encourage growth. And it did. The economy was in better shape than the media thought. Yes, there’s fraud on Wall Street, but we’ll get over it. The reason for this is very simple.

One word. Two syllables. Credit. Lots of it.

Real estate suddenly became a popular commodity. People were sick of the stock market. After the dotcom bonanza, 9/11, and the crash of 2002/3, who could blame them? At least real estate is bricks and mortar, and it always goes up over ten years, and rates were low enough to get an affordable mortgage on very unaffordable homes.

So, American consumers started buying houses. People began refinancing their homes for much better rates, and before we knew it, the economy was recovering. In fact, life looked better than ever. Everyone had a BMW, and the banks were lending money so fast they looked like ticket scouts outside Fenway Park.

And then, one of the great evils was born. The shadow bank.

You’ve heard of them. Countrywide. Fremont General. New Century. Institutions specifically set-up to lend. They borrow a billion from a commercial bank, then lend it out to people who need mortgages. It’s that simple. And as a consumer, you no longer had to visit your bank for a loan, you visited a shadow bank. Because they aggressively marketed home loans. They offered rates you never imagined. They had all kinds of twists and flowery language to convince you to borrow, and buy a home. And you did. The American Dream is to own a home with a two-car garage and suddenly you had one, for a rate so low it was cheaper than renting a two-bed in the wrong part of town.

This had a positive impact on housing prices. Supply became scarce. Demand surged. Prices rocketed. Economics 101. “Mr. Jones. Will you buy this home for $500,000?” “I don’t have $500,000.” “How about zero down at 3%. That’s only $1250 a month. Do you have that?” “Yes.” “Good, then sign here.”

Housing boom. Everyone is doing it. And they are all making money. Demand drives prices. And was there ever demand!

Demand does something else. It begs for more inventory. Construction boom. 

The year now is 2005, and prices in San Francisco have exploded to the upside. Locations with vistas of the Golden Gate Bridge are out of reach for most people now.  But the feeding frenzy hasn’t even pretended to slow down. People are upgrading their homes across America, and California is particularly active.

Big construction outfits are building new communities in and around the San Francisco Delta, and it isn’t long before the asparagus fields are sold off to big outfits like Centex and Beazer, who erect entire communities surrounded by asparagus!

This whole bonanza pumped up the globe in a very simple loop. Rates were 1%. Banks had cheap money from the government. Lending rates for businesses were lowt, an opportunity the Shadow Banks exploited. Consumers could have lines of credit for low interest rates, especially mortgages from the Shadow Banks. New homeowners could borrow against their homes, called “home equity loans” for pennies on the dollar. With that money, they strolled off to Home Depot for DIY kits to jazz up their new homes. They bought cars, cellphones, TVs, furniture. American retail boomed.

American retail chains became cash rich. However, instead of spreading the wealth to American manufacturers, they turned to the cheapest, most efficient labor force on the planet to boost their profit margin. China, which suddenly had an unprecedented manufacturing boom. Shipping lanes come alive throughout the globe, shipping coal, oil, chemicals, steel into China, and carrying their exports to America. It’s a booming economy. The Chinese are rich, and fantasies about taking over the world start clouding their judgment. Which might be why they decided to build 20 Chicagos and exchange their bicycles for Cadillacs.

However, China couldn’t spend the money fast enough. They had trillions to spend, and there’s only one thing you can do with a trillion dollars. That’s 1000 billion, by the way. A million millions. The answer is United States Government bonds. And with this amount of money flowing into the US from China, the rates could stay low. We basically had a situation where we were borrowing wealth from China we’d created!

However, one little detail in this giant orgy of wealth had been overlooked. The whole thing was borrowed money. It was credit, created by 1% interest rates.

What if these people who couldn’t afford these homes suddenly defaulted? What about the credit card payments… those thousands of Americans balancing several cards at a time? Why wasn’t anyone afraid that this great nation was suddenly racking up debt like palettes in a shipping yard? What happens to a population, who’s levered to the hilt, living one paycheck from bankruptcy, if they catch a cold? 

Armageddon happens. The world freezes. But why were the shockwaves so devastating? How did Wall Street become so involved with this madness? Why did a homeloan in an asparagus field outside San Francisco bring down Lehman Brothers and put Bank of America on life support? How did Lehman’s bankruptcy obliterate hedge funds around the world? What was the connection? What really happened at Lehman?

Get the real answers. July 2009.
“A Colossal Failure Of Common Sense – The Inside Story Of The Collapse Of Lehman Brothers

A Colossal Failure Of Common Sense

THE eagerly awaited Wall Street blockbuster. Written by a perfect combination of authors. By Lawrence G McDonald, the hard-driving Lehman Brothers trading Vice President, and the #1 New York Times bestselling author Patrick Robinson, the man who wrote Lone Survivor for the Navy SEAL Marcus Luttrell.

Direct from the heart of Lehman Brothers, the bank that smashed the world’s economy. An incredible blow-the-lid-off account of the greed, the misjudgements, the dreadful stupidity of men who should have known better. Revealed by a man who was there, the eyewitness, Larry McDonald. Anyone, laymen or expert, can understand the crucible of a Wall Street trading floor. This is a black box of secrets. And now Larry McDonald rips the lid off.

PRE-ORDER YOUR COPY ON AMAZON.COM TODAY!colossalbullapproved

The EYEWITNESS Account of Lehman Brothers Published in June!!

It’s called “A Colossal Failure Of Common Sense.” This is THE book on the financial crisis, written by ex-Vice President of Lehman Brothers, Lawrence G. McDonald, and the #1 NYTimes bestselling author, Patrick Robinson. Click on some links below to read all about it. This is the first book written by a senior Wall Street trader in the history of publishing.

PRE-ORDER YOUR COPY ON AMAZON.COM TODAY!

Finally…. a Lehman Brothers Eyewitness writes a book!

This will be the first and ONLY book that describes exactly what really happened inside the walls of 745 7th Avenue – the Lehman Brothers headquarters, written by a former Vice President, with the #1 New York Times bestselling author, Patrick Robinson.

PRE-ORDER YOUR COPY ON AMAZON.COM TODAY!

THE JACKET COPY

They stand alone – the zillion-dollar questions of the financial crisis : What the hell happened at Lehman Brothers? And why was it allowed to fail, with aftershocks that rocked the global economy? In this news-making, often astonishing book, a former Vice-President of Lehman gives us the straight answers – right from-the-belly-of-the-beast. Larry McDonald is the first senior Wall Street trader ever to write such an expose – revealing at last the culture and unspoken rules of the game like no book has ever achieved before.

PRE-ORDER YOUR COPY ON AMAZON.COM TODAY!

A Colossal Failure of Common Sense is couched in the very human story of McDonald’s Horatio Alger-like rise from a Massachusetts “gateway to nowhere” housing project, to the New York headquarters of Lehman Brothers, home to one of the world’s toughest trading floors. He posed as a pizza delivery man to get past receptionists, to score interviews at brokerage firms. He peddled frozen pork chops, door to door, to hone his sales skills, desperate to realize his dream of working on Wall Street.

We get a close-up view of the other participants in the Lehman collapse, those who saw it coming with a helpless, angry certainty. We meet the Brahmins at the top, whose reckless, pedal-to-the-floor addiction to growth finally demolished the nation’s oldest investment bank. The Wall Street we encounter is a ruthless place, where brilliance, arrogance, ambition, greed, and all the human traits, combine in a potent mix that sometimes fuels prosperity, but sometimes destroys it.

McDonald’s gripping story of the firm’s death spiral is a modern-day thriller, studded with incredible revelations.

The collapse of Lehman Brothers was no surprise and didn’t have to happen. In fact, CEO Richard Fuld and President Joe Gregory were confronted with warnings on three occasions — starting as far back as 2005 —that the property market, on which they were betting the ranch, was teetering toward collapse. Fuld and Gregory turned their backs each time.

PRE-ORDER YOUR COPY ON AMAZON.COM TODAY!

McDonald paints a vivid picture of life inside Lehman, where the isolated and reclusive chief executive ‘reigned’ in his sumptuous 31st floor office, accessible only by private elevator. From this Ivory Tower so much of the firm’s brightest talent was driven out of the door. The full significance of the Lehman bankruptcy remains to be measured. But this much is certain: it was a devastating blow to both America and the world beyond. And it need not have happened. This is the story of why it did.

The Authors

LAWRENCE G. McDONALD was, until 2008, vice president of distressed debt and convertible securities trading at Lehman Brothers. He ran an extremely successful joint venture between the firm’s fixed income and equity divisions and was one of Lehman’s most consistently profitable traders, responsible for bringing in over $83 million in trading profits. He was heralded by many colleagues at Lehman for both his early 2006 call on the subprime crisis and the $46 million in trading profits realized from it. Mr. McDonald is also co-founder of Convertbond.com, named by Forbes magazine as “Best of the Web” from 2000-2003, specifically citing it as the web’s premier source for convertible securities information, valuation and news. In October 1999, before the dot-com crash, the site was successfully sold to Morgan Stanley and remains a property of that firm.

PATRICK ROBINSON wrote Lone Survivor for the US Navy SEAL Marcus Luttrell, It was one of the biggest selling military books ever published, 1 on the New York Times bestseller list for months in 2007. Mr. Robinson is also known for his bestselling US Navy-based ‘techno-thrillers’. The autobiography, which he wrote for Admiral Sir Sandy Woodward, One Hunded Days, was an international bestseller. He lives in Ireland, and spends his summers on Cape Cod, Massachusetts, where he and Larry McDonald sail together.

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Brief Summary – A Colossal Failure Of Common Sense

“It’s not where you start in life… it’s where you finish.”

Lawrence G. McDonald has just written the inside story of the collapse of Lehman Brothers, to be published by Random House this summer. It’s about how the world’s greatest investment bank got rich on toxic financial instruments called CDO’s, buried their balance sheet with mountains and mountains of debt, credit derivatives and ludicrous gambles, then blew up like a stick of dynamite in a mining shaft, obliterating the world economy as it went.

The book was written with Patrick Robinson, the #1 New York Times bestselling author of Lone Survivor. This latest book, which frankly knocks the spots off Liar’s Poker, is a gripping thriller, and explains the financial world in such basic terms, anybody can understand it. It’s appropriately called A Colossal Failure Of Common Sense.

 

Oh, and that’s the Wall Street bull on the jacket. Not the Merrill Lynch bull! It’s an ironic symbol of how capitalism went bananas during one of the great bull markets, until it all came crashing down last Fall, as the Fed let the 158-year-old firm go to the wall. Some would say it was a misguided decision. Others will tell you that the government couldn’t keep bailing everyone out. Bear Sterns, Fannie, Freddie… maybe Lehman was a step too far. But the real story is far more sinister, revealed for the first time by the man who watched it happen.

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