The Worst Market Crisis in 60 Years

I didn't create this title. This is the title of an article in FT by George Soros, someone for whom we probably don't need any introduction. In the article, he provides great discussions on the root cause, reason and consequence of the current credit crisis, which has widened far beyond just the initial subprime area.

A normal boom and bust credit cycle is simply easy credit causing people to push up property price, in turn increasing the amount of credit, which creates a self-reinforcing cycle until the bubble bursts. This has happened many times throughout history, and when bubble bursts, people suffer a little but after some time, things come back.

But things has changed a lot during last 10-20 years. In order to prevent recession and eliminate credit bust period, the Fed and government have intervened repeatedly whenever financial market is at risk. They have flooded the market with easy credit by providing large liquidity and lowering short term interest rate. As a result, they have prolonged the bull market and credit boom period as long as they can to keep people happy.

As someone said it well "treating a drunk by giving him another drink." Whether people will have to pay for this kind of temporary shock therapies by suffering deeper pain in a very long bear market with dead credit, has been beyond their consideration. Good job, Greenspan. Poor Bernanke, as people said, timing is everything.

That is the main reason behind the deregulation of financial institutions during last 20 years, since Fed needs Wall St to fully utilize and leverage all the easy credits they provide. Pretty soon we are at the mercy of investment banks doing their own risk management with no reserves required (and we know they have done a great job of evaluating risk on both their products and their own firms!), not like the good old days when commercial banks were required by regulations to have sufficient reserves to make loans and mortgages. And unnecessarily keeping interest rate low forever has further increased the level of easy credits and liquidity. 

At the same time, do our rating agencies provide any oversight to help the public? At least not at the complex structured product area such as mortgages. Rating agencies and structured product groups, the most profitable groups at Wall St, are basically using the same black box computer models and assumptions to price and rate their exotic, complex MBS products no one can understand. Trust the computer, sure. But why do we still need the rating agency then?

Whatever the structured groups say, we will take their word for it. But did someone just say computer is garbage in and garbage out? Well, previously everything out of their shops was triple A rated, not garbage. Somehow now they are all junk rated and become garbage. It must be our own fault to mess them up."Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market.

Investment banks' commitments to leveraged buyouts became liabilities. George continues, "If federal funds were lowered beyond a certain point, ..the ability of the Fed to stimulate the economy comes to an end." Where is that point? George Soros didn't want to say, but he probably feels it is getting pretty close and this is why he wrote this article. Maybe at or slightly below 3%?

For believers of the theory that low interest rates can save us, just look at Japan for the last 10-15 years; zero or even negative interest rate has not help much to stimulate the economy after the burst of both stock and real estate bubbles. His most interesting statement is: "the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency."

What he didn't say is, if US dollar loses its reserve status, there is no obvious replacement currency, at least not at this moment. What happens then? One possible, likely and logical solution could be that countries around the World would consider gold as their reserves again. Does George Soros imply that we are returning to gold standard?