THE GAME CHANGERBy George Soros 2009-02-04
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
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
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 short- selling? 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
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-from- equilibrium situation – global deflation
and depression – except by first inducing its opposite and then
To prevent the US economy from sliding into a depression, Mr Obama
must implement a radical and comprehensive set of policies. Alongside
the well- advanced 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.
The writer is chairman of Soros Fund Management and founder of the
Open Society Institute. These are extracts from an e-book update to
The New Paradigm for Financial Markets – The credit crisis of 2008 and
what it means (PublicAffairs Books, New York)
作者：乔治•索罗斯(George Soros)为英国《金融时报》撰稿 2009-02-04 选择字号: 大 中 小
本文作者是索罗斯基金管理公司(Soros Fund Management)董事长、开放社会协会(Open Society
Institute)创立者。本文选自《金融市场新范式》(The New Paradigm for Financial
Markets)电子书修订版（PublicAffairs Books, 纽约）