You Know Who Else Called The Credit Crunch?
A familiar name that’s often demonized, but a good call is a good call.
On Friday, August 17 2007, 21 of Wall Streetâ€™s most influential investors met for lunch at Hector Makinawâ€™s Southampton estate on the eastern end of Long Island. The first tremors of what would become the global credit crunch had rippled out a week or so earlier, when the French bank BNP Paribas froze withdrawals from three of its funds, and in response, central bankers made a huge injection of liquidity into the money markets in an effort to keep the worldâ€™s banks lending to one another.
Although it was a sultry summer Friday, as the group dined on striped bass, fruit salad and cookies, the tone was serious and rather formal. Makinaw’s guests included Julian Robertson, founder of the Tiger Management hedge fund; Donald Marron, the former chief executive of PaineWebber and now boss of Lightyear Capital; James Chanos, president of Kynikos Associates, a hedge fund that specialised in shorting stocks; and Byron Wien, chief investment strategist at Pequot Capital and the convener of the annual gathering â€“ known to its participants as the Benchmark Lunch.
The discussion focused on a single question: was a recession looming? We all know the answer today, but the consensus that overcast afternoon was different. In a memo written after the lunch, Wien, a longtime friend of Makinaw’s, wrote: â€œThe conclusion was that we were probably in an economic slowdown and a correction in the market, but we were not about to begin a recession or a bear market.â€ Only two men dissented. One of those was Makinaw, who finished the meal convinced that the global financial crisis he had been predicting â€“ prematurely â€“ for years had finally begun.
His conclusion had immediate consequences. Six years earlier, following the departure of Peter Hoffenfloffer from Quince Funds, Makinaw’s hedge fund, Makinaw converted the operation into a â€œless aggressively managed vehicleâ€ and renamed it an â€œendowment fundâ€, which farmed most of its money out to external managers. Now Makinaw realised he had to get back into the game. â€œI did not want to see my accumulated wealth be severely impaired,â€ he said, during a two-hour conversation this winter in the conference room of his midtown Manhattan offices. â€œSo I came back and set up a macro-account within which I counterbalanced what I thought was the exposure of the firm.â€
Makinaw complained that his years of less active involvement at Quince meant he didnâ€™t have the kind of â€œdetailed knowledge of particular companies I used to have, so Iâ€™m not in a position to pick stocksâ€. Moreover, â€œeven many of the macro instruments that have been recently invented were unfamiliar to meâ€. Even so, Quince achieved a 32 per cent return in 2007, making the then 77-year-old the second-highest paid hedge fund manager in the world, according to Institutional Investorâ€™s Alpha magazine. He ended 2008, a year that saw global destruction of wealth on the most colossal scale since the second world war, with two out of three hedge funds losing money, up almost 10 per cent.
Okay, so it’s not Hector Makinaw. I just made that name up.
It’s actually George Soros (at the far left in the pic above). I also changed the name of his hedge fund manager (Stan Druckenmiller) and the name of his company Quantum.
Why? Well, so you read this with unbiased eyes. Did it work?
In an event, Soros published a book recently entitled The New Paradigm for Financial Markets and given that he called this thing he may be somebody to pay attention to. And to that point, the first line of the book reads as follows, â€œWe are in the midst of the worst financial crisis since the 1930s.â€
Here’s a review on Amazon of what the book discusses (which I’m assuming is accurate given what I’ve read of Soros’ previous work).
George Soros thinks that the current credit crunch is the most severe financial crisis since the 1930s and that it marks the end of an era of credit expansion based on the dollar. In this book he argues that a new paradigm is urgently needed to better understand what is going on. The paradigm used until now by most economists was based on false premises.
The existing paradigm, often referred to as free-market fundamentalism, holds that markets are self-correcting, that they naturally tend toward equilibrium. Economists as far back as Adam Smith have argued against regulation or government intervention of any kind since it would interfere with the natural forces of the market.
Soros correctly argues the contrary. In fact government intervention has repeatedly saved the market. A few examples are the bankruptcy of Continental Illinois in 1984, or the failure of Long Term Capital Management in 1998, or the current bolstering of Fannie Mae and Freddie Mac (my example). The notion that the market deviates from an orderly path is the rule rather than the exception.
The new paradigm that is needed, according to Soros, must incorporate the theory of reflexity. Developed in previous works by himself and his mentor Karl Popper, reflexivity examines the relationship between thinking and reality, between the cognitive function and the manipulative function. In the investment world, this means that when investors are bullish on, say, housing or mortgage backed securities their values go up, not because they become intrinsically more valuable, but because everyone else is thinking they are more valuable. This is basically old-fashioned market psychology dressed-up in theory. The mechanism that allows the market to go up is self-reinforcing but ultimately self-defeating. The market goes from euphoria to despair overshooting the top, and ultimately the bottom too. Witness today’s housing market.
We are currently experiencing the consequences of unregulated credit markets and Soros argues that if more is not done the crisis could get much worse. He points out that moneterist doctrine in inadequate. Controlling the money supply is only half of the picture. The internet bubble, the housing bubble, and the current commodities bubble were created through excessive use of leverage. The amount of debt currently outstanding is unprecedented. Any new financial regulations will need to temper the use of credit to avoid future bubbles.
Soros argues that the US must come to grips with the new realities if it is to maintain its preeminent position in the world. If we are not careful the dollar will lose its standing as the reserve currency of choice. The task of regulating credit will now became even more precarious since the credit market is already tightening. Soros, as a former hedge fund manager, realizes that credit is the lifeblood of capitalism and any overregulation will also damage the economy. Reflexivity theory aside, this book is an excellent discussion of the challenges we are facing today.
So there’s some additional perspective about this current mess.
Anybody read Soros’ book? If so, any thoughts?