The Banking Crisis

MUMBAI: Billionaire George Soros has warned financial market investors to brace themselves for more pain as losses from the subprime meltdown mount and banks and hedge funds reel under the effects of reckless investment and lending. “The situation is going to get worse before it gets better,” the maverick investor and philanthropist told a teleconference with Asian journalists on Thursday.

“We are probably having recession and food price inflation at the same time. That is what makes this different. This is a serious financial crisis of our lifetime. It is the end of an era,” he added. He said the Basel II agreement that governs how banks have to maintain capital is totally misconceived. “It will have to be reworked and we need a Basel III for a new order.”

Mr Soros’ comments come at a time of deep crisis for global financial and stock markets. Banks have been forced to write off billions of dollars made in risky subprime mortgages and have faced steep losses. Global equity indices have plunged and credit growth, especially in the US, has been squeezed, raising the spectre of recession for the second time in this century.

On Thursday, the Bank of England cut interest rates by 50 basis points to 5% and the European Central Bank (ECB) warned that the risks to economic growth were far greater than anticipated. “Tension may last longer than initially thought and have a broader-than-currently-expected impact on the real economy,” ECB president Jean Claude Trichet said.

Mr Soros blamed loose regulation for the current crisis arising out of a fundamentalist market ideology. He repeatedly emphasised that it was the worst in our life time. “Regulators failed to regulate. They thought that excesses were random and that the market would always come to an equilibrium. They were adopting the wrong paradigm,” he said, adding the losses from risky subprime mortgages could top $1 trillion.

“What we know so far is just the full effect of the decline in value of the financial instruments held by banks. This does not include the possible decline in the quality of the loans they hold,” he added. Banks and hedge funds are highly leveraged, he said. In the past few years, many banks have also acted as hedge funds and built up huge debt. “All that has to be deleveraged. There is a painful wealth destruction that is currently happening.”

The IMF last week estimated the losses from subprime at about $1 trillion. Several banks, including UBS, Citibank, Merrill Lynch, Credit Suisse, have been forced to write off billions of dollars.

Mr Soros blamed the regulators for not being strict and watchful enough. “They thought the ideal way to deal with this is control money supply and credit. But credit conditions and money supply don’t go hand in hand. They should have focused on curbing credit expansion, introduce margin requirements for loan. In many cases, they have margin requirements, but they have not used it. The belief that markets can regulate themselves is a false idea,” he said.

Credit default swaps, Mr Soros said, is like a Damocles’ sword hanging over global markets. Excessive speculation has led to an enormous growth in their size and markets have grown unregulated. “Nobody knows the counterpart risk in case of a default. At about $45 trillion, they are five times bigger than the government bond market.”

Mr Soros also expressed concern over rising food prices. “It is a matter of grave concern, especially to countries who are heavy importers. It has the potential to cause social and political disruptions. This is yet another element in the current crisis,” he added.

He said there are similarities between the current state of the US economy and Japan’s lost decade such as that country’s accumulated bad debts and the bursting of the real estate bubble. But he said the US is taking steps to douse the fire while the Japanese took a long time in taking action.

On the question of the dollar, Mr Soros was in a playful mood. “I know exactly where the dollar is going but I won’t tell you. That is a joke.” He added that there is no question that there is reluctance on the part of central banks to accumulate dollars. “There is no alternative to the dollar as well, so there is a flight away from currencies into other asset classes on the part of sovereign wealth funds and institutional investors.” Mr Soros also cautioned over excessive regulation.

“Central banks and regulators have obviously failed. But while markets are imperfect, regulators are imperfect as well. They tend to be bureaucratic. We don’t want to go back to the situation in the 1930s when markets were in a narrow strait-jacket.”