The Crisis Spreads to the Periphery
Soros was careful to point out that the current crisis was not due to an “external shock.” It was a self-generated crisis, with origins within the US economy. The pivotal mistake, he said, was allowing Lehman to default. “Effectively, the financial system melted down,” Soros said. “The authorities then had to throw all considerations of moral hazard out the window.”
“Basically, all developed countries decided they could not allow another major institution to default,” he said. “They effectively guaranteed the deposits in all institutions.” But Soros said there was an unintended consequence of this: a flow of capital from the periphery to the center of the financial markets.
As the crisis unfolded, countries on the “periphery” (emerging markets) were forced to guarantee bank deposits to stem the flow of capital out of their markets. The IMF was then forced into a new mission: protecting the countries on the periphery “against the storm at the center.”
“Unless the US now leads an international effort to stabilize the system, including the periphery, the system will not continue,” said Soros. He expects the next president to do this. Otherwise, he said, a different system will emerge, and the US will not be able to exert the same influence it currently enjoys.
Soros admitted underestimating the global fallout from the credit crisis. “I thought the periphery would be more unscathed than what turned out,” said Soros. The Chinese and Indian markets went down a lot more than he anticipated. He also admitted that he did not anticipate the recent strength of the US dollar. Both mistakes have cost him money in his fund management.
Marxism meets Capitalism
Soros recounted the causes of the housing bubble, noting in particular that lenders assumed they could reduce risk with the geographical diversification offered through securitization. In fact, he said, this actually increased risk, because it separated the agent and the principal. Those who loaned money and earned fees – the agent - were disconnected from the homeowners that were on the hook for the payments – the principal. The agent and the principal did not share the incentive to pay the mortgage in a timely manner.
“Marx made the same mistake,” Soros said: “He didn’t understand the agency-principal problems” that would arise when everything was nationalized.
Now there are 20 million homes with mortgages that exceed home values, Soros believes. As employment rises, he said, it will be “socially acceptable” for homeowners to walk away from their homes. He believes that mortgage balances need to be reduced to 80% of the current value of homes to provide an equity buffer, in case home values fall by another 10% or so.
Soros said the current administration has been “consistently lagging” in its policy responses, specifically singling out Treasury Secretary Henry Paulson. “Paulson did not recognize the severity of the crisis and did not take the necessary steps,” Soros said. He also admitted he did not correctly forecast the severity of the crisis himself.
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