Archive for November 18th, 2008

Soros pushes his theory of reflexivity

November 18, 2008

After hearing on Lehman, AIG, regulators, Senate Oversight Committee had a hearing on hedge funds and its role in the crisis. The hearing was divided into 2 panels . First panel was of economists and second of hedge fund managers. Pretty big names appeared for hearing.

On reading the testimonies, one comes across mix views and there is no clarity. However, most of them lean towards the need to regulate hedge funds.

The most interesting of the testmonies was of George Soros ( that is a given):

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact-that the defect was inherent in the system-eontradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting.

This is typical Soros stuff.  After this, he says to understand the events, we need a new theory

This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

Soros then explains the way the distorted views lead to bubbles and problems. It has helped a certain section:

Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

He then explains the political economy of financial markets and says efficient markets ideology became mainstream as crisis impacted the developing (those that had poor macro, poor institutions etc). Whenever crisis occurred in US like LTCM , Savings and Loan crisis etc authorities intervened and a largescale crisis was averted. And the ideology continued to prosper. He says he cried wolf 3 times:

I have cried wolf times: first with The Alchemy ofFinance in 1987, then with The Crisis ofGlobal Capitalism  1998, and now. Only now did the wolf arrive.

However, his theory lacks predicting events in fin markets. It helps more explain them. So, it still lacks a much needed aspect of fin system. He then says the regulators need to do something to manage the build oup of bubbles as their policies lead to creation of the same. He does not have very kind words for Alan Greenspan as well.

Finally on hedge funds he says:

Regarding hedge funds, it has to be recognized that hedge funds were also an integral part of the bubble which now has burst. Hedge funds grew to approximately $2 trillion of capital which at times controlled as much as $10 trillion or more in assets. But the bubble has now burst and hedge funds will be decimated. I would guess that the amount of money they manage will shrink by between 50 and 75 percent. During the current financial crisis, many hedge fund managers forgot the cardinal rule of hedge fund investing which is to protect  investor capital during down markets. It is unfortunate that much of the money raised by hedge funds in pursuit of alpha

Interesting throughout. Typical Soros.


UBS releases a new compensation model

November 18, 2008

The role of incentives in generating this financial crisis has been much debated and criticised. As a result, some changes are happening.

First, most of the govt. packages have this as the first condition- no bonuses, golden parachutes etc. Second, role of compensation structures has been included in various reports prepared for future financial regulation. Third, even companies are waking up to their mistakes and making changes.

UBS has released a report detailing changes in its compensation model. The detailed report is here and there is also a FAQ on the same. In the new model, following issues have been done away with:

  • Variable compensation was strongly aligned with short-term results, without consideration for the quality or sustainiability of the bank’s performance
  • The system for determining variable compensation did not sufficiently take into account the risks assumed.

As a result, there will be no variable pay (bonus etc) for this year for the top management and for others it will be reduced.

This is actually in line with what Goldman Sachs has done but is different as it has issued a separate report and plans to stay committed to the plan.  Just to recall, UBS was also the first one(and I think only one) to issue a report explaning its losses to the shareholders. The report was highly complex and one could not make any sense of the problems.

I am yet to read the compensation report. Hope this is simpler.

Are econ/fin professors completely off the curve?

November 18, 2008

The economics/finance professors have been accused for not being able to predict the crisis. Infact they are often blamed for instead engaging in random academic work not benefiting anyone.

I came across this article (thanks to ASBfor the pointer) in American which says the contrary. It summarises research of economists which has pioneered work that has led to predicting wrongdoing in certain segment of financial markets (mutual finds, backdating options etc) and economy (sub-prime borrowing). The links to the various papers cited have not been provided and would involve some google searching.

A good article which shows things are not as bad as they are made out to be.

However, what is needed is to make the academic work more mainstream and spread the message via newspapers, blogs etc. Apart from Ed Gramlich (who predicted risky sub-prime borrowings), Jay Ritter (IPO mismanaging), I haven’t heard of any of the professors and their work.

Assorted Links

November 18, 2008

1. MR on liquidity trap

2. WSJ Blog points Summers says fiscal stimulus has to be sustained

3. Mankiw points to a debate on auto industry bailout

4. Rodrik points to some papers on trade and growth

5. Fin Prof points to an article on Fed and the next bubble

6. ALB points to the problems with most common sources of financial advice- friends and family

7. PSD BLog points Argentina revisits 2001

8. CTB points to signs of crisis

%d bloggers like this: