(All the transcripts from the FCIC will be easily accessible in the future a link to my scribd account on the timeless reading page.)
The markets are always on the side of exuberance or fear. It’s fear and greed. Right now greed has the better of it, which is rather nice (for investors) as long as it doesn’t get out of hand
Coho Capital 2Q20 Commentary: Podcasts, The New Talk Radio
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In his book, The Alchemy of Finance: Reading the Mind of the Market, George Soros writes.
Reflexivity is discordant with equilibrium theory, which stipulates that markets move towards equilibrium and that non-equilibrium fluctuations are merely random noise that will soon be corrected. In equilibrium theory, prices in the long run at equilibrium reflect the underlying fundamentals, which are unaffected by prices. Reflexivity asserts that prices do in fact influence the fundamentals and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles.
While George Soros is not a value investor persay, he does try to take advantage of discrepencies in the market sometimes using contrarian investing. I have searched for this quote for days but have not found it, but I believe Soros said he has made most of his money on value plays and not macro plays. 1969 Soros established the Quantum Fund,which over the next 30 years produced annual returns of 32%!
In Soros’ book,The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means(May 2008), described a “superbubble” that had built up over the past 25 years and was ready to collapse. In an FT article written in early 2009, Soros stated ” I positioned myself reasonably well for what was coming last year”.
Soros was asked to testify before the Financial Crisis Inquiry Commission. Which wass a ten-member commission appointed by the United States government with the goal of investigating the causes of the financial crisis of 2007–2010
The full transcript of the audio tape of George soros is available below in both scribd and text format.
2010-10-04 FCIC Staff Audiotape of Interview With George Soros Soros Fund Management LLC
10/04/2010 FCIC staff audiotape of interview with George Soros, Soros Fund Management, LLC
Gary Cohen: And we’re here from the Financial Crisis Inquiry Commission. I’m Gary Cohen. I’m the general counsel. My colleague Kim Shafer and Donna Norman. We are charged with investigating the causes of the financial crisis in 2008 and 2007 and perhaps in 2009 and ’10. And this is a on the record recording that we’re doing with George Soros. We’re in New York and it is 4:55. We’re a little bit early. And Mr. Soros, are you – you are okay with us taping you on this?
George Soros: Absolutely.
Gary Cohen: Very good. And would you like to introduce yourself [0:00:38] [Indiscernible]?
Michael Vachon: My name is Michael Vachon. I am an employee of Soros Fund Management and I advice Mr. Soros on a number of topics.
Robert Johnson: I’m Robert Johnson. I’m the executive director of the Institute for New Economic Thinking, formally a partner with Soros Fund Management many years ago and work frequently with Mr. Soros on questions of financial regulation.
Gary Cohen: Pardon me. Well, we’re going to ask you questions about, you know, why was there a financial crisis, what it was actually and what part of the crisis. We’re going to ask you questions about regulation system issues and things of that nature. And at any time there are things that you want to add to me, you can be as candid as you wish. We’ve had some remarkably candid conversations today with a couple of other people we’ve spoken to.
What do you think was the financial crisis itself? Where do you think it stopped being the beginning of a recession say and became what it turned out to be the great recession or the great almost depression?
George Soros: Sometime, I would say, early in 2007. Maybe on March or so and when the first bankruptcies occurred. But it was something that could be anticipated much earlier than that. And those of us who did actually did not expect that it will take that long for it to develop.
Gary Cohen: What do you think – when you say it started in 2007 and you anticipated it, what did you see that made you think it was happening and then – and that delayed it from actually popping, I guess, if you can recall what happened in ’08.
George Soros: Well, I have a conceptual framework in terms of which I interpret financial markets and that conceptual framework actually led me to anticipate it. And maybe – I think that the process started in – it goes back as far as the early 1980s. It went through a number of phases. There have been a number of [0:03:48] [Inaudible] and each time the – they were [Inaudible] and prevented a financial crisis from affecting the economy. And the measures they took then reinforced across the process making the bubble bigger until it became so big that in fact the authorities are unable to contain it and that’s how we had the financial and the crash of the – in – following the bankruptcy of Lehman Brothers in 2008.
Gary Cohen: What do you think started in 1980, in the ‘80s? I mean, what was going on?
George Soros: The [0:05:00] – a [Indiscernible] an interpretation of the financial markets and an ideology connected with it came to them and dominated public policy. I call it market fundamentalism for short.
Gary Cohen: You mean that deregulation philosophy …
George Soros: That had basically globalization of financial markets and deregulation of financial markets and a spirit of financial innovations which were based on this false ideology.
Gary Cohen: Do you think the innovations were – had value or were they valueless or were they …
George Soros: They had some value but they also had some negative effects. And you have to look at them case by case.
Gary Cohen: How did the financial system change over that 30-year period or so that you thought accelerated it and did you think that [0:06:34] [Inaudible]?
George Soros: Well, the – one of the remarkable features is still the growth of credit and leverage. Generally speaking, credit has been growing significantly faster than GDP ever since the end of the Second World War but it’s really only in – around 1980 that the situation got out of hand. But the growth in credit then and leverage could be observed even before that.
Female Interviewer: And it started – I looked at that charts in your book comparing the two. And when you say in the 80s it started getting out of hand, just that the percent of debt to GDP started on a much steeper incline or there’s something else going on?
George Soros: Well, it had – it – globalization and deregulation became dominant.
Gary Cohen: Do you – you mentioned that there were actions taken in response during the 80s and I guess in the 90s. Are you talking about the famous – the Greenspan Put of …
George Soros: You mean the – just keeping it accessible [0:08:25] [Phonetic]?
Gary Cohen: Yes, yes.
George Soros: That’s part – that is part of it but I think it’s much more. But [Indiscernible] it was a belief that financial markets basically correct their own excesses and then to a [Indiscernible] equilibrium and therefore, they don’t need to be regulated.
Gary Cohen: Well, Greenspan has gone on record saying that he was mistaken in that and chairman [0:09:14] [Indiscernible] is the chairman of the commission I think at one of the hearings where he said – I think he said without an “oops” moment where there was a mistake made. Do you think that crisis was avoidable at any point in that period of time or do you think it really was inevitable starting, you know, maybe in the turn of the century perhaps.
George Soros: No. I think that it was certainly avoidable. [0:10:00] Generally speaking, the course of events is indeterminate and is determined by the actions of the – and decisions of – that people take as they go along and so different decisions would have got very different results.
Female Interviewer: So let’s go back to 2007 and I believe that was when you started writing your book that you ultimately called The Crash of 2008. So, what did you see then that troubled you in the markets that made you concerned that we were heading to a difficult – into a difficult time?
George Soros: Well, the focus, the main focus of that book was clearly the housing industry and within the housing industry, the securitization of mortgages and the introduction of unsound instruments like those subprime loans and these are rates [Phonetic] which are the main ties of deception.
Gary Cohen: We – you know, clearly you’ve …
Female Interviewer: Could – so – but I just want to build from there if you – if I might. So, you saw the signs in housing and you’ve written about the super bubble and the expansion of credit.
George Soros: Yes.
Female Interviewer: But back in ’07, were you aware of – concerned about fragility in a large financial institution? Has …
George Soros: Yes, yes, yes.
Female Interviewer: What else did you see …
George Soros: Actually, I would have to probably refresh my memory but I wrote an article in January 2007 where I warned of the impending troubles that was in financial times.
Gary Cohen: Yes
George Soros: Maybe we can …
Michael Vachon: I can send you all of George’s articles. If you look on his website actually on GeorgeSoros.com, you’ll see all the [0:13:04] [Indiscernible] articles there. I can look at …
Female Interviewer: Okay.
Robert Johnson: [Inaudible]
Female Interviewer: We’ll find it. We did try to prep but …
George Soros: Yes.
Female Interviewer: … not as completely. And …
George Soros: So I can’t at this point recall exactly how I put my concerns but the focal point was of course the trouble in the housing market but the – there was also deregulation which has broken – which has broken down the various firewalls that separated different markets. And so the – I mean, if I recall, in [0:13:56] [Inaudible] identified trouble in the subprime market and – but he considered it to be an isolated problem of maybe a – which could cause the damages of a hundred billion dollars or so and the system could easily absorb it. The – what he left out of account was the contagion, how the collapse of one market had then led to dislocation in other markets and with remarkable speed. And that was because the networking of connections between the various markets and [0:15:00] the spread of the effects from one market to the other.
Female Interviewer: So, you wrote in the second version of your book that you – while you had anticipated a lot …
George Soros: Yes.
Female Interviewer: … and sounded warning bells that you didn’t foresee …
George Soros: The actual bankruptcy of Lehman Brothers. And I consider that being a mistake on the part of the regulators, the authorities to allow it to happen.
Female Interviewer: And …
George Soros: Now of course they have their excuses but I think that they are feeble excuses because one of the legal powers for intervening may not have been purely defined. I believe that they could have done whatever was necessary if they had considered it necessary and it could have been then later accepted and [0:16:29] [Indiscernible]. In other words [Phonetic], the Fed in my opinion has very wide discretionary powers [Indiscernible].
Female Interviewer: But this is something that confuses me …
George Soros: Yes.
Female Interviewer: … about reading your book that on the one hand, you say one of the causes of the super bubble is that whenever there were problems in the system, regulators fixed it up, patched it up and that there were negative consequences of the continuation of the bubble as a result. Yet here, we get to Lehman and forgive me when I’m misunderstanding. You’re saying it’s a mistake …
George Soros: Yes.
Female Interviewer: … that they did not patch that one up.
George Soros: That’s right. That’s right. Basically, the authorities impose a market discipline except when the system itself is in danger. And at that time, they intervened and suspend the discipline that is supposed to guide them and do whatever is necessary to keep the system together. It is generally described as moral hazard and that is the – at the core of the – of what happened because it is in fact the moral hazard that allowed the bubble to get so large because the measures that the authorities took had the effect of reinforcing the imbalances that caused the crashes, whichever crash that you are talking about.
You know, there’s generally crashes brought upon by excessive use of credit and leverage and the way you deal with it is to increase the credit and leverage that is available and in fact, substitute the credit of the state for the credit [0:19:29] [Indiscernible].
And that is in fact what happened after the mistake was made and Lehman was allowed to go bust because effectively, the financial authorities of the – internationally gave an undertaking not to allow it to recur again [0:20:00] and those [Inaudible] institution will be allowed to fail.
So, after the mistake of Lehman Brothers, we’ve made the – that caused the crash. Again, the same mechanism – same methods was used to see – to restart the economy and to make the crash – was temporarily threatened [Phonetic] to leave that – to go to collapse with imbalance and the system has actually recovered. But the amount of leverage in the economy has actually – have been increased and the balance sheet of the Federal Reserve have come from 600 billion to two trillion in a very short order.
Female Interviewer: So are we still in the super bubble?
George Soros: This remains to be seen actually because to control the situation, the authorities had to engage in a very delicate two-phase maneuver.
First, they had to replace the credit [Indiscernible] and only in the second phase can they withdraw it. But we haven’t apparently reached the second phase because we are now about to engage in a yet another injection of quantitative easing. So, the simile I use is the – when a car is skidding then you first have to turn the wheel in the same direction as the skid and only when you regain control can you hold to correct the direction of the car. And that is in fact what the authorities undertook after Lehman Brothers.
Female Interviewer: Do you think they should have allowed Bear …
George Soros: Pardon?
Female Interviewer: Do you think the authorities should have allowed Bear to fail?
George Soros: Should …
Female Interviewer: Should have allowed Bear Stearns to fail?
George Soros: No, I don’t think they should have allowed to – Lehman to fail.
Female Interviewer: No, I was asking if – there are those who feel that if the smaller investment bank Bear Stearns have been allowed to fail, then the market may have prepared for the possibility of failure …
George Soros: Yes.
Female Interviewer: … and pulled back and the Lehman crisis might have been different.
George Soros: I don’t think the – and I think history shows that the authorities have effectively always erred on the side of caution and they send it and came to the rescue when there was any danger of systemic collapse. The first major instance of which I am aware of was by the Bank of England in nineteen – I think – I would have to again check the date, ’74, when they intervened to protect the quasi-banks [0:24:25] [Phonetic]. Slater Walker was one of these institutions that I knew particularly well. But there were a number of them. They were outside the supervision of the Bank of England but nevertheless, they intervened because they were afraid that if they failed, they would endanger the clearing banks which were under [0:25:00] their supervision. So they extended [Indiscernible] or further than their actual mandate called for and that was the first time that has happened and it happened repeatedly both here and abroad.
So the argument that by allowing some institutions to fail, the moral hazard can be cured has no credibility because when the event actually occurs, then the authorities will always first save the system rather than to test that theory. You know, they can’t afford to take the – they feel that they can’t take the chance of testing that theory further. In fact, that the institution was systematically – would bring down the system or not. So, it is an excuse for refusing to accept the implication of the fact that there is this implicit guarantee by the authorities and which means that they have an obligation to prevent this guarantee from being used.
Female Interviewer: As a hedge fund manager, do you rely on that implicit guarantee in making your decisions?
George Soros: No, I don’t. Although I can recall an instance going way back when I had a very large position in British government bonds and I was very close to blowing up and I thought of actually if it really came to that, that I will go to the Bank of England and ask them to protect them and their [0:27:24] [Indiscernible] market. So, even I had a – and even before these whole things developed then because this goes back to – actually to early [Indiscernible] and so early 80s. So in the ‘79 or – no – you know, the early 80s. So even I have this implicit guarantee in my mind.
Female Interviewer: So is there a solution then to …
George Soros: Yes, there is.
Female Interviewer: … [Indiscernible] problem?
George Soros: Yes, there is. I think that the authorities have an obligation. It’s their duty to prevent a guarantee from being called up on and therefore they have to impose renovations that make it unlikely that – so then we have to have potential behavior and deposit-taking institutions subject to the authority of the central bank and the central bank then has the ability and the duty to regulate. And as I had just mentioned that the extent that the – that guarantee even beyond the institutions. They stay regulated in order to protect those institutions. So that guarantee is a very strong one and it’s actually, I think, quite reasonable that you don’t want the system to collapse.
You don’t want to take chances with that because, you know, seeing what happened when Lehman was allowed to go bust. Within two days, Hank Paulson had to reverse himself and within the week, he had to ask for a lavish blank check from congress.
Gary Cohen: The system had gotten very fragile. Some – one of our other interviews, [0:30:00] the person that we’re talking to said that he thought that had there not [Indiscernible] subprime crisis. They thought it would have been something else …
George Soros: Yes.
Gary Cohen: … because of the nature of the system. I mean, is that something you share?
George Soros: Yes. As – until you learn the lesson that correct the false doctrine that was guiding both market participants and regulators. It was liable to go there. Although one could never tell what it will be that would cause it. Then eventually – for instance in the case of housing, it became clear that that was going to be the focal point. But before that, you could foresee that it would happen but you couldn’t foresee where it would happen.
Gary Cohen: Because of what? Because [0:31:18] [Indiscernible]? Because …
George Soros: Because basically …
Gary Cohen: They’re connected there. So …
George Soros: Basically bubbles have two components. It is usually a misconception, you know, of – you know, there’s a trend that actually occurs in reality and then there’s a misconception related to that trend. And I would say the most common kind of [0:31:56] [Indiscernible] bubble which is the – recurs most frequently. The – which is in real estate, the housing or commercial real estate or it might be agriculture.
The trend is the easy availability of credit and the misconception is that the easy availability of credit doesn’t inference the value of the collateral. Therefore you can lend on the collateral because it’s safe and had – that misconception recurs in very different ways and it was very much present in the housing bubble. Right? Because of the synthetic use of [Indiscernible] were based on that misconception that by diversifying the risk, you actually reduce the risk and did not take into account that by introducing those instruments, the whole system gets – the whole market gets inflated. That’s what [0:33:31] [Indiscernible]. So …
Male Speaker: Bless you.
George Soros: In the case of this [0:33:57] [Inaudible] the prevailing trend was the continuous extents of credit due to the intervention of the authorities and the misconception is that markets correct their own excesses. The fact was of course that it was the authorities that prevented markets from collapsing. It wasn’t the markets that corrected their excesses. It’s the intervention of the authorities that kept it together and that intervention reinforced the excess namely the availability of credit and that’s how you had one crisis after another. Each time the authorities intervened, took care of the failing [0:35:00] institution, lowered interest rates where appropriate or made some other arrangements to make credit available which then got the process – keeps it – gets the process going.
Gary Cohen: Do you – so how would the system have corrected itself? Obviously it didn’t. But would there have been – do you think there should have been [0:35:35] [Indiscernible] regulation and do you think that the Greenspan theory of self-correcting markets or self-policing markets – you know, because market correction could be don’t save Bear, don’t save Lehman. Let everything fall apart and then the market corrects itself. Meanwhile there are people [Indiscernible]. So I don’t know that Greenspan was actually in favor of that.
George Soros: Well, Greenspan argues that the advantages of innovation, financial innovation are so great that the price you pay when occasionally things get out of hand and you have to pick up the pieces, that price is a smaller price to pay for the benefits of that increased efficiency and so on that come from financial innovation.
I disagree with that because the – mainly because the people who pay their price are not the same who get the benefit from the innovations. So it’s a distributional problem and there is no mechanism for compensating around the – after the crash of Lehman, the collapse of Lehman, Greenspan said that he could no longer make that claim because he saw the damages being too big.
Since then, I think he has probably reversed his view and still has gone back to arguing that the price is worth paying. So that was a moment of concern and that – but then you see there are some of us who have the same views in that the system works very well except once in a hundred years. And I guess now that the event has occurred, the hundred year [0:38:44] [Indiscernible] as fast we can go back to business as usual.
Gary Cohen: Some people did see that, that it would, you know, [Inaudible]. You know …
George Soros: Paul Volcker saw it.
Gary Cohen: And [Indiscernible] and, you know, he believed [Phonetic] Paul Krugman. He was writing about – Paul Krugman.
George Soros: Yes.
Gary Cohen: But nobody or at least not too many people [0:39:17] [Indiscernible] than the people in The Big Short who made a lot of money out of it. Not too many people acted on it. Is there – is [Indiscernible] a groupthink in the economic system that doesn’t allow itself to look outside of whatever the conventional wisdom is?
George Soros: Well, there certainly is groupthink but you have more than one group in any market I will say and there were – that was a group that saw it coming. But [0:40:00] unless you get the timing right, you can easily be forced out of that view and as I say, the – it’s really only by accident that you get it completely right. In fact I would say it does happen I suppose but trying to make up my knowledge here of cases. Basically, market participants are almost always wrong but you – the – it’s a characteristic of a bubble that they may see as [Indiscernible] aside. So let’s say a banker that refuses to play the game is liable to be removed from his position or the bank is liable to be acquired by another bank that is much more daring and therefore has much as a result.
Because the – it’s the characteristic of a bubble that it reinforces the misconception but those who adopt [0:41:47] [Phonetic] the misconception are actually right in that misconception until …
Gary Cohen: They’re not.
George Soros: Until they’re not. And they gain credibility and wait until the group is – say – until there’s nobody else to be here [Indiscernible] over. That’s when the catastrophe actually takes place.
Female Interviewer: I expect you to disagree with this point of view but some have argued that derivatives are beneficial because they allow the negative sentiment to be articulated in some way.
Male Speaker: Yes, yes.
Female Interviewer: And so for example from that point of view, the ABX index which went down considerably …
George Soros: Was a useful instrument to have, yes. I don’t disagree with that view actually.
Female Interviewer: Okay.
George Soros: Because I have – shorting gives a market the [0:43:18] [Indiscernible] otherwise wouldn’t have because in a crash, the only people who are left to buy or – how the people are [Indiscernible]. So, having short positions is a very useful thing to have and just as the fact that you can sell stock short makes the market for – gives them more stability. The fact that you can sell a synthetic instrument short has the same effect.
Where I have been rather emphatic is in calling credit default swaps a toxic instrument and that is a somewhat more complicated argument which has – we have to take several steps. One is that going long and selling short is asymmetric. They are not symmetrical and because if you buy a stock and you’re wrong, your risk automatically is reduced. [0:45:00]
And whereas if you sell it short and you’re wrong, your risk is automatically increased and therefore, it’s easier. It’s more advantageous to be long. It has – the risk reward dynamically moves in your favor. The dynamics of the risk reward calculation favor being long rather than short. And that’s why in any market, you got many more long positions than you have short positions. We’ve had [Phonetic] a few exceptions.
In the case of CDS, this calculation is reversed because it’s the – if the buyer of the CDS that has the benefit of reduced risk and the seller that has the risk has the danger of increased risk as demonstrated by the collapse of AIG, which was the largest seller of CDS. And they thought that they were selling an insurance product and actually, they were selling their [Phonetic] market [0:46:29] [Indiscernible] and they didn’t realize that.
And they thought that the insurance product was overpriced and as an insurance price, they were right. As an insurance product, they were right. But as a warrant, it was underpriced as Paulson, John Paulson correctly recognized and so did Goldman Sachs because Goldman Sachs was [Indiscernible]. And so then that’s the first step of the argument.
The second segment of the argument is that actually [Indiscernible] can succeed and therefore an instrument that facilitates [0:47:31] [Indiscernible] is a very dangerous instrument because it can validate itself. But – and this is particularly true when it comes to a financial institution whose business model depends on the ability to have access to credit.
And so if the cost of credit goes up, the business model is endangered and by – if the price of the CDS goes up, the cost of borrowing goes up. Therefore an attack through CDS can be self [Indiscernible] especially in selling – if you combine selling short the stock and combining CDS, you can in fact destroy an institution that otherwise would not be endangered and I think that played an important role in the case of Bear Stearns and probably Lehman Brothers also.
Gary Cohen: Sorry …
Female Interviewer: I …
Gary Cohen: She’s [0:49:00] [Indiscernible]. She describes that.
Female Interviewer: Thank you for that conceptual framework and answer and I also read it in your book and thought about that. But I’m still confused.
George Soros: So basically …
Female Interviewer: Not by …
George Soros: … synthetic instruments can be very useful. I mean, you know, for instance, warrants. It’s the simplest thing. It can be a useful form of financial instrument allowing people, you know, an option to buy. Options can be useful, saving in options [Phonetic]. But there are dangers involved and therefore, it is [0:50:00] the duty of the financial regulator to understand those instruments and to regulate them.
So I argue in favor of registering the financial instruments, these synthetic instruments just as you have to register a natural instrument. A – share issues have to be registered with [Indiscernible]. The same way I think synthetic instruments should also be registered and if you have an instrument that’s a failure on the regulated exchange so it’s one formula that can be registered as a class. If you have a tailor-made instrument, a designed instrument, it has to be – it should be registered individually because it’s different from the others.
And the cost and the inconvenience of registering tailor-made instruments would drive the greater use of registered instruments [Indiscernible] from the unregulated exchanges and this would greatly reduce the risks in the financial system. This is something that was ignored and left out and I think if you pointed it out in your report, I think it will be – bring something very [0:51:57] [Indiscernible]. You know, there’s – the right way to regulate is through registering. It doesn’t forbid because if you forbid the use of – you would deprive people from having the benefits because there are benefits in having those instruments.
Gary Cohen: So you talked about deregulations starting in the 80s and I think some people say that maybe going back to the 70s with the Airline Deregulation under Carter. But certainly Greenspan, when he became chairman of the Fed, was in – of the view of self-regulating market. So, it started as you said in the 80s and it continued until now. So that’s a reason why we got here. But can you go underneath that? Do you – is it the nature of the system? I mean, that – I guess a number of our people that we’ve interviewed, whether the crisis was caused by a failure of a system or a failure of individual people of the – of men, women. Not that many women. So that had there been better people running financial institutions and watching out for – whether it was Citibank or Fannie or Freddie or AIG or whether it’s just the system itself created its own …
George Soros: No, I think it’s something else. It’s the ideas or theories that guided the people that were at fault. It’s not the – and so, it’s the theories adopted by the – by both regulators and the market participants that proved to be false. It’s the efficient market hypothesis and the rational expectations theory. So it’s really the theories that the interpretation of financial markets, that the prevailing, we call it, dogma or – what’s the word? A paradigm, the prevailing paradigm that is to be – that is responsible.
Robert Johnson: I would just add to that. One of the implicit [0:55:00] operating assumptions using these theories was the existence of infinite liquidity and when there was default risk and there was not the capacity to do arbitrage, many of these derivative instruments and many of the options [Indiscernible] cannot be priced.
George Soros: [Indiscernible] the assumption was continuous markets, continuity, market continuity and it’s continuity that caused these crashes. So, the assumption is – of the efficient market type was that markets are continuous. Now, they’re not. They’re – and you’ve got a discontinuity and then you have a crash. So this is how you had for instance the crash connected with the – in [0:56:02] [Indiscernible] the – with the …
Robert Johnson: Portfolio insurance?
George Soros: Portfolio insurance. Portfolio insurance is a synthetic product. It was based on this false assumption of continuous markets and which then encouraged a lot of people [Indiscernible] portfolio insurance didn’t [Indiscernible] didn’t take into account the effect of so many people owning portfolio insurance. So when the insurance was invoked, the market collapsed. And that’s a typical example of …
Robert Johnson: In this instance, the complex derivatives were devised according to computer models and the mark to model valuation. When liquidity became disrupted and the markets weren’t continuous, there was a great distance from the actual price one could achieve in the marketplace. And so people in the managements – you were asking about people versus systems.
In the marketplace, people were assuming things on the computer model. We were saying 96 cents on the dollar when in fact they could only get 20 cents on the dollar in the market. And then as the regulators looked over this, if they assumed that an asset is worth 70 cents more than it is, then their view of how much capital [Indiscernible] and their sense of fragility is a [0:57:40] [Indiscernible] underestimate. And so the underlying mistakes in theory and assumptions led to a – we might call a mirage of how solid the [Indiscernible] that when the theory’s shortcomings were revealed in the marketplace added a great deal of anxiety to the crisis and to the propagation of the crisis.
Female Interviewer: That leads to the …
George Soros: Pardon?
Female Interviewer: … question. That leads to a question I had for you, Mr. Soros, which was how you feel about mark to market accounting and its role in the process. Mark to market accounting and – mark to market accounting and its role in the crisis …
George Soros: Yes. It’s …
Female Interviewer: … if it had one.
George Soros: Yes. No, it’s – that’s a very complicated issue because it clearly – the market had a time of – create uncertainty at times to estimate the position of a financial institution if their assets were marked to market. And if that figure is available, the uncertainty is less. If the figure is not available, then the markets are forced to – market [0:59:12] [Indiscernible] are forced to make their own guesses. And at times of uncertainty and fear, they tend to overestimate it and that makes their situation worse.
And so, having mark to market values available would have to remove that kind of uncertainty and stabilize the system. That’s what [Indiscernible] are supposed to do and that’s why they have some value except that the methodology is not always convincing. But [01:00:00] – so, I think disclosure of mark to market values is highly advisable.
Whether a bank should be allowed to hold to maturity and thereby be exempt from – you know, when it comes to the aggravation [Phonetic] of the capital and the capital requirements. There – that’s much more questionable because that could put into – that could invoke this self-reinforcing process of destruction and the –effectively the authorities would be conducting there in some – on the banks if the market [Indiscernible]. So, it’s – that’s why it’s very complicated. So I think, you know, having the figures available would be – that’s the advice whether a – but how to determine the capital requirements is another issue.
Now, I would like to come back to a question that you were beginning to formulate about regulation and systemic risk. And the important thing that does need to be emphasized – and I haven’t actually emphasized it sufficiently in my book because it wasn’t called for at that time. That aggravators are also – aggravations are also [01:02:05] [Indiscernible] perfect and it’s impossible to have a perfect [Indiscernible] system and therefore, why markets – how inherently unstable and therefore they need regulation.
And the regulation has to recognize that it is also imperfect and subject to regulatory arbitrage and like a foresight on the part of the regulators. And that’s what makes the task of designing regulations so difficult and a good regulation could – recognizes all the imperfection. That’s a very important point.
Gary Cohen: You think that the failure to do so, if indeed there was a failure which seems to be – certainly there was some failure, is because of the nature of the regulatory process or because the influence of firms whose interests are not …
George Soros: Yes. All of the above. First of all, it’s inherent in the human condition. Somebody that – you know, so the fundamental to understanding social and economic affairs. Second, regulations by that nature under [Indiscernible] and always lag behind reality. There’s always time. The markets are much faster in recognizing reality than bureaucrats. Thirdly, political influences. Regulations are subject to politics.
And the process of the financial – that led to the financial reformat was the illustration of the defects of how regulations are formulated, how legislation is formulated. So this is what makes the situations [Indiscernible]. I mean there was – the fact that you – [01:05:00] markets need to be regulated doesn’t mean that the regulations will do their job that they are supposed to. In fact, they will be – they will always fail and if this is recognized, then the regulations themselves will prove to be flexible enough that they might have a better chance of catching up with the new developments. If you establish timeless rules, you ensure that those rules will be inadequate.
Gary Cohen: You know, we’ve done a lot of interviews and it’s easy to become pessimistic and listening to all of you guys, people who are at the very top of the financial industry in one aspect or another, senior regulators, business executives, hedge fund experts, managers. Not one of them has said if people had only done this or if that, things wouldn’t have happened. Are you – I guess – do you share the view of Jamie Dimon when he testified before commission 9 months ago, 10 months ago now?
He was asked about crises and he said, well, the crisis is what I told my daughter [Phonetic] it was. And he said it was something that happens every 5 or 10 years. Is that your view is that there’s really nothing to be done in your – are you …
George Soros: I disagree with you. I disagree with you and actually I’m very eager to help you formulate something. I mean I’m at your disposal to spend as much time with you as you find appropriate to try to convey to you what I – my understanding of financial markets because I think that it really could be helpful to throw light on – I mean, the conceptual framework that is in my books provides a better interpretation of how things actually happened and the prevailing paradigm which has failed.
So, perfectionism [01:07:47] [Indiscernible]. The – our understanding of the word will always – there will always be a gap between our understanding and what really exists in reality. So, since this is inherent, the size and nature of the gap is all important. So, if you understand that there’s always a gap, you are already ahead. You’re already better off than if you don’t recognize it. And the prevailing paradigm didn’t recognize this so it failed. It – the – what makes social affairs so complicated, more complicated to understand the natural phenomena is that this imperfect understanding of the participants actually influences the course of events in form of the elements that you need to understand. Okay?
This is what you – what is called Knightian uncertainty. Knight actually recognized this. [Indiscernible] recognize this. Modern economists forgot it. They just forgot it and they – since they existed on – in natural science, you can actually produce theories which are [01:09:31] [Indiscernible] prevalent because it doesn’t have thinking participants. Thinking introduces this element of uncertainty. Okay? And economics sought to rival natural sciences.
Now natural sciences are also not perfect because scientists are not perfect. But the participants, they are not [01:10:00] participants in the natural phenomenon. Okay? In economics, they are participants so the theory that economists propose actually influence how financial markets operate. So, that’s the point that needs to be – I think has to be the starting point of the explanation of what happened. And so I hope it’s …
Male Speaker: It’s the – we call it the Soros uncertainty principle.
George Soros: Human uncertainty …
Male Speaker: Yes.
George Soros: … is what I call it. Yes. And it’s – you know, it’s like Heisenberg’s uncertainty …
Male Speaker: Sure.
George Soros: … principle except that in Heisenberg’s uncertainty principle, things change their behavior around the quantum
Gary Cohen: Yes.
George Soros: … particles that just we – however, Soros human uncertainty principle or the efficient market hypothesis or Marxist theory of history changes history and changes the behavior of markets.
So then the effect is that if hedge fund operators have read my book and recognized that, you know, the market is highly effective [01:11:37] [Phonetic] have actually made markets more simple.
Male Speaker: Well, particularly if everybody, I guess, is using – is applying the same set of rules because then you’ve got a positive feedback …
George Soros: Yes.
Male Speaker: … which tends to isolate. It’s a little bit like perhaps like [Indiscernible].
George Soros: Yes, very much so.
Male Speaker: Yes.
George Soros: Very much so. Basically, [Indiscernible] in financial …
Male Speaker: Yes.
George Soros: The negative feedback is self-defeating [01:12:11] [Indiscernible] brings it closer to …
Male Speaker: Equilibrium.
George Soros: Closer to equilibrium. Positive feedback is self-enforcing it. So a false idea that has positive feedback appears to be …
Gary Cohen: Correct until …
George Soros: … correct until it’s – yes, until it’s …
Gary Cohen: Right.
George Soros: … proven false.
Gary Cohen: Yes.
George Soros: So – and that’s the – that this key. I frankly think that if you want to give a good explanation though of what happened, you have to make that clear to – and that puts everything into perspective and there were also abuses and so on. But it wasn’t just the abuses that created the – the excesses are inherent in the system. You see, when I see a bubble, I buy [Phonetic]. So, don’t count on me as a market participant who prevents bubbles from developing. Therefore, controlling asset bubbles has to be the role of a regulator because market participants cannot be counted on because they cause it.
Gary Cohen: William McChesney Martin …
George Soros: Pardon?
Gary Cohen: William McChesney Martin of the Federal Reserve here I met a long time ago said it was his job to take away the punchbowl when the party got good.
George Soros: Right.
Gary Cohen: And I guess we haven’t had anybody who saw their job quite that same way.
George Soros: Yes.
Gary Cohen: I think Greenspan was on record in saying that it wasn’t his job to stop the bubble but rather it is to clean it up afterwards.
George Soros: That’s right.
Gary Cohen: Yes.
George Soros: And he explicitly rejected the responsibility for correcting – for [01:14:16] [Indiscernible] asset bubbles because they said we don’t have the instruments and in fact, he was right. He is right in saying that monetary [Indiscernible] are not appropriate for controlling asset bubbles. In fact, the use of [Indiscernible] can contribute to asset bubbles developing if you keep interest rates too low too long as he did. It was a very important factor. Right?
So, you need other instruments which have been introduced after the [01:15:00] 1930s. Minimum reserve requirements, margin requirements and you need to actually vary them. That’s very important that it’s not – they shouldn’t set them once and for all. But your margin requirements for instance in the stock market were very important at one time and the [Indiscernible] influenced how much credit you could get from securities. And they were also often changed and actually the development of synthetic instruments was very largely to overcome …
Gary Cohen: The margin …
George Soros: … the margin requirements.
Gary Cohen: Yes.
George Soros: So the [Indiscernible] is a very important function of synthetic instruments. So the – and the Chinese central bank raised the capital requirements on Chinese banks 17 times leaving them to – into the 2008 and then lowered it much, much more quickly after this.
So, this is a – this should be part of the response to this crisis and you should not set those requirements once and for all because you have to recognize that monetary control doesn’t control credit because of this divergence between perceptions and reality. You could have a certain amount of monetary supply and you could have a – you could have a credit expansion or credit construction [01:17:23] [Indiscernible] reduction depending on the mood of the market and there was markets who have moods, which is – which was disregarded by the [Indiscernible] market in hypothesis. I think you have to go there in explaining what happened.
Gary Cohen: It’s a very difficult task to do that. People seem to want …
George Soros: Yes.
George Soros: And in fact probably some wrongdoing.
Gary Cohen: Yes, yes, yes.
George Soros: Yes, yes.
Gary Cohen: Yes. What about …
George Soros: There are wrongdoings so I think you can find some.
Gary Cohen: But I would assume that a system properly engineered should take into account of their own wrongdoing because that’s the nature of people instead of something else.
George Soros: Yes, yes, yes.
Gary Cohen: Do you think that the situation was exacerbated by this – what is now called the global savings glut and all of those Chinese saving money instead of spending it?
George Soros: I disagree with Krugman on his explanation which is – again, as I’ve said, [Indiscernible]. I think it was much more due to the Chinese government controlling the exchange rate and also the Asian countries having suffered from the Asian crisis in 1997 and building up their currency reserves and keeping their currencies down and – rather building up. Excessive – well, the IMF considers excessive reserves. Those are the glut – that’s the glut of savings and also in the [01:19:47] [Indiscernible] rate has a lot to do with the glut of savings. You know, there are hedge funds, the borrowing [Indiscernible] and [01:20:00] very low interest rates and using it to build up positions [Indiscernible].
So it’s a little more complicated than just excessive savings but there is a – there was a fundamental imbalance in the sense that the Chinese were very happy or the Asians generally, but the Chinese more lately, very happy to produce more and consume less. And we were very happy to consume more and produce less.
Michael Vachon: It’s a perfect marriage. But I think it’s the perfect marriage.
George Soros: It seemed we all take that [Indiscernible]. It just could have continued for a long time yet but it was an important imbalance. And is it very important? No. It’s really the households that because of the housing bubble that then – be saved and that’s what undid the balance.
Robert Johnson: By the way, when you referred to the savings glut, you said that you disagreed with Krugman. I think it was Ben Bernanke who was the proponent of the savings glut.
George Soros: But I thought Krugman has the same. Isn’t he …
Robert Johnson: … agrees with you about the exchange rate plans [Phonetic], you know …
George Soros: They – but doesn’t he – he had this [Indiscernible] excess savings.
Gary Cohen: Yes, he does. That’s a big thing. His parable of the babysitting cooperative, I don’t know if you’ve ever read that. [01:21:58] [Indiscernible] book and it’s one of his articles. He has this story about a babysitting cooperative in Washington where everybody gets babysitting credits but nobody would spend them and so nobody can then get a babysitter and so the babysitting cooperative went into a recession basically. And this is the way you fix that. It was on his latest article that was in his book. He said you fix that by increasing the [Indiscernible] of babysitting credits. So you just flood the market with the excess of liquidity and that frees up people to go out and have babysitters.
George Soros: Joan Robinson in her book Money [Phonetic] had this parable – or not – supposedly that in a German town there was a shortage of taxis. So they put in an ordinance that at every taxi station, there has to be at least two taxis standing. And as a result, you couldn’t get any taxis because they all …
Male Speaker: Understand the consequences.
Male Speaker: It’s almost 6:30 and …
Male Speaker: Yes.
Male Speaker: [01:23:12] [Indiscernible]
Gary Cohen: Okay. Well, do you have any wrap-ups, Kim, Donna?
Female Interviewer: I don’t have anything that’s worthy of a wrap-up.
Gary Cohen: That’s [Inaudible].
George Soros: But I’m at your disposal in the future if the – I don’t know who is writing the report.
Gary Cohen: Yes. We’re not sure …
Female Interviewer: Many people.
Gary Cohen: There are a lot of people. It’s a group effort, a group effort. We have a lot of writers and a lot of leaders and the commissioners are also reading it. So it will – there will be a lot of authors. Yes, yes, yes. Is there any parting besides [Indiscernible] condition of systems? Anything that you would like to leave us with as we go back out into the cold, outside air [01:24:02] [Phonetic]?
George Soros: Yes. I think we can – we’ve touched on most of the – I think the need for regulation and the imperfection of regulations on the other hand is important to bring in and I think the – this – the moral hazard is something that has a lot of [Indiscernible] to it and I think the idea that somehow, you know, leaving [Indiscernible] or whatever will allow the failure of [01:25:00] an institution. It means unbelievable until it actually is implemented and even then.
Gary Cohen: Well, we’re seeing – I mean I hope we won’t see. But …
George Soros: Yes. So – but that’s an excuse for avoiding the needs for regulation.
Robert Johnson: One thing that you and I have frequently discussed is that the scope of regulation enforcements and bankruptcies is not international.
George Soros: Right.
Robert Johnson: And so to avoid moral hazard …
George Soros: Yes.
Robert Johnson: … too big to fail firms …
George Soros: … actually – yes, actually is worth putting on record. That is that globalization spread like a virus, like a disease because based on deregulation, the countries that [Indiscernible] would lose financial capital. Financial capital would escape, would go to countries where it’s least regulated and least [Indiscernible]. And it doesn’t work in reverse. Once you’ve recognized the means for regulation, the fact that it has to be international because we have global markets, makes the task of the regulator more difficult.
So globalization makes the task of the deregulator easier and the task of the regulator more difficult. That, I think, is a very important point.
Robert Johnson: And the other topic that we’ve talked about frequently is the – what you might call deterioration in the quality of information because so much is allowed to be off balance sheets.
George Soros: Yes. I mean that and we can’t go out …
Male Speaker: Yes. And [Indiscernible] a lot of people talk about the – about that whole, you know, special investment vehicles and, you know, that …
Male Speaker: … yes, yes.
George Soros: But I think is [Indiscernible].
Robert Johnson: Have you talked to Frank Partnoy? Frank is a lawyer at the University of San Diego Law School and he does a presentation where he shows a balance sheet and he says, look at this. This looks great. And then the next slide is the same thing but it says Citigroup 2007, ’08 and ’09 and he basically says nothing that happened that was relevant to the crisis at Citigroup was on balance sheet. It was all off balance sheet and he describes that deterioration very well.
Gary Cohen: Well, we’ll talk to him [01:28:03] [Phonetic]. Thank you very much.
Female Interviewer: Thank you. It was [Inaudible]. [01:28:05]