House Oversight Testimony: Hedge Funds and the Financial Market

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slug: house-oversight-hedge-funds-2008 year: 2008 title: "Testimony before the House Oversight Committee: Hedge Funds and the Financial Market" source: https://www.govinfo.gov/content/pkg/CHRG-110hhrg56582/html/CHRG-110hhrg56582.htm type: testimony

George Soros testifies before the U.S. House Committee on Oversight and Government Reform (Chairman Henry Waxman), November 13, 2008, alongside James Simons, John Paulson, Philip Falcone, and Kenneth Griffin. This page carries Soros's oral statement in full and every Q&A exchange in which he participated; the full official record, including the other witnesses, is preserved in this knowledge base's raw archive (KB_raw/george-soros/investment/house-oversight-hedge-funds-2008.txt).

Mr. Soros. Thank you, Mr. Chairman. We are in the midst of the worst financial crisis since the 1930's. The salient feature of the crisis is that it was not caused by some external shock, like OPEC raising the price of oil. It was generated by the financial system itself. This fact, that the defect was inherent in the system, contradicts the generally accepted theory about financial markets. The prevailing paradigm is that markets tend toward equilibrium. Deviations from the equilibrium either occur in a random fashion or are caused by some sudden external event to which markets have difficulty in adjusting. The current approach to market regulation has been based on this theory. But the severity and amplitude of the crisis proves convincingly that there is something fundamentally wrong with it. I have developed an alternative paradigm that differs from the current one in two important respects: First, financial markets don't reflect the underlying conditions accurately. They provide a picture that is always biased or distorted in some 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. I call this two-way circle of connection between market prices and the underlying reality reflexivity.'' I contend that financial markets are always reflexive, and on occasion, they can be quite far away from the so-called equilibrium. In other words, it is an inherent characteristic of financial markets that they are prone to produce bubbles. I originally proposed this theory in 1987, and I brought it up to date in my latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means.'' I have summarized my argument in the written testimony I have submitted. Let me recall briefly the main implications of the new paradigm for the regulation of financial markets. The first and foremost point is that the regulators must accept responsibility for controlling asset bubbles. Until now, they have explicitly rejected that responsibility. Second, to control asset bubbles it is not enough to control the money supply. It is also necessary to control credit because the two don't go in lock step. Third, controlling credit requires reactivating policy instruments which have fallen into disuse, notably margin requirements and minimum capital requirements for banks. When I say reactivate them, I mean that the ratios need to be changed from time to time to counteract the prevailing mood of the markets because markets do have moods. Fourth, new regulations are needed to ensure that margin requirements and the capital ratios of banks can be accurately measured. The alphabet soup of synthetic financial instruments, CDOs, CDSs EDSs and the like, have made risk less apparent and harder to measure. These new products will have to be registered and approved before they can be used and their clearing mechanism has to be regulated in order to minimize counterpart risk. Fifth, since financial marketings are global, regulations must also be international in scope. Sixth, since the quantitative risk management models currently in use ignore the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that have been incorporated in the Basel Accords on bank regulation. Basel 2, which delegated authority for calculating risk to the financial institutions themselves, was an aberration and has to be abandoned. It needs to be replaced by a Basel 3 which will be based on the new paradigm. How do these principles apply to hedge funds? Clearly hedge funds use leverage and they contribute to market instability in times like the present when we're experiencing wholesale and disorderly de-leveraging. Therefore, the systemic risks need to be recognized and more closely monitored than they have been until now. The entire regulatory framework needs to be reconsidered, and hedge funds need to be regulated within that framework. But we must be aware of going overboard with regulation. Excessive deregulation is at the root of the current crisis, and there is a real danger that the pendulum will swing too far the other way. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism itself. That's because regulators are not only human but also bureaucratic and susceptible to political influences. It has to be recognized that hedge funds were an integral part of the bubble which has now burst, but the bubble has now burst, and hedge funds will be decimated. I will guess that the amount of money that they manage will shrink between 50 and 75 percent. It would be a grave mistake to add to the forced liquidation currently depressing markets by ill-considered or punitive regulations. I'd be happy to expand on these points in greater detail in answering your questions. [The prepared statement of Mr. Soros follows:]

Mr. Soros. Yes, I think that some hedge funds do pose systemic risk. And I think particularly leveraged capital was built on a false conception--I talked about the false paradigm on which our financial system has been built. And that was actually embodied in leveraged capital, which was very--which basically assumed that deviations from--are random.

Chairman Waxman. Do you believe this justifies greater Federal regulation?

Mr. Soros. Pardon?

Mr. Soros. Yes, it does.

Chairman Waxman. Thank you.

Mr. Simons.

Mr. Soros. As I have said, I think the regulators need to monitor positions more closely than they have done until now. But disclosing it to the public can be very harmful in many ways. And I think that the publication of short positions, for instance, practically endangers the business model of long- short equity investors--it is not our business, it is the other hedge funds that do that--because of the reaction of the companies whose shares they were selling short. Mr. Davis of Virginia. Let me ask this. I asked Mr. Waxman, and he is comfortable with me asking this. Do you have any opinions on what the Treasury Department is doing now with the Troubled Asset Recovery Plan? How they can deploy that maybe better than they are doing? In light of the fact that the $700 billion is not actually being used to buy up troubled assets but to purchase equity stakes in financial firms, Secretary Paulson has indicated that Treasury may start purchasing stakes in nonbank financial firms. And do you think any hedge funds might take advantage of such an offer? Anybody want to opine an opinion on that? Mr. Griffin, I will start with you.

Mr. Griffin. Congressman Davis, I believe that the decision to focus on injecting equity or preferred equity into the banking system versus buying assets will create a larger effect for all of us and is a good decision on a relative basis. So, in other words, I applaud the Secretary of Treasury for making the decision to increase the equity capital base of the banking system at this moment in time. Of course, we have a difficult decision to make ahead of us: Do we expand TARP to include the nonbanking sector? And if we do so, where do we draw the line? I think that is a very difficult decision that we have to make in the weeks and months ahead. Obviously, the economy as a whole is slowing down, and we need to keep Americans employed. And I believe that we are going to need more stimulus packages to keep our economy as close to full potential as possible.

Mr. Falcone. I have been in favor of TARP to a certain extent considering that it could be a safety net for isolated incidents. I don't believe, however, that the money should be used for random purchases of assets because of the lack of clarity as it relates to what the institutions will do with that capital and what benefits it will do for the individual consumer. And I furthermore do not think that it should go above and beyond the financial institutions.

Mr. Soros. I am on record being very critical of the original TARP proposal. And I would like to go on record saying that while it is a great improvement that it is not used for removing toxic securities, but for equity injection, the way it is done is not an adequate or acceptable way, that if it were properly done then $700 billion would be more than sufficient to replenish the gaping hole in the banking system and to encourage the banks to start lending again. And the way that this should be done would be to ask the examiners to determine how much capital each bank needs to bring it up to the required 8 percent. Then the banks would be free to raise that capital or go to TARP and get an offer. But TARP should only underwrite the issue, and not actually take it on. But underwrite it on terms that the shareholders would be likely to take it on. And only if the shareholders don't take it would TARP take it on. Then you would have replenished the banking system, you would then reduce the minimum lending requirements from 8 percent, let's say, to 6 percent--the minimum capital requirements--and the banks would be very anxious to put that very expensive capital, because equity capital is expensive, to good use to get a good return on it by actually lending. So that would solve that problem. And as far as the toxic securities are concerned, I think the first thing is to renegotiate the mortgages so that people would actually stay in their houses, and you remove the pressure of foreclosures, which are liable to push down the value of mortgage securities way below that. That is an undone business that has to be urgently attended to. Mr. Davis of Virginia. Thank you all. Mr. Towns [presiding]. Let me tell my colleague he has no time to yield back. Let me just ask the question and just go right down the line and get an answer from each of you. All of you have successfully navigated the recent problems in the economy which appears to have blind-sided the people on Wall Street, and of course the people here in Washington. I don't think we can pass up this opportunity to explore what it is that you knew that allowed you to get so far ahead of everyone else when it came to predicting what would happen in the markets. I would like to go right down the line. Right down the line. We will start with you, Mr. Griffin, go right down the line.

Mr. Griffin. Sir, the last 8 weeks have been a challenging 8 weeks for Citadel. We have had a very successful 18 years holistically, but we have had a tough time in the last 8 weeks as the banking system around the world came close to the verge of collapsing. I think what is very important to note is what has happened in the last 8 weeks looks like nothing that any of the traditional risk management metrics would have shown as a realistic possibility. I think it is very important for everyone to keep in mind in terms of policy decisions on a going forward basis we had a panic in the money market system, we had a panic in the banking system, and we have had very negative consequences as a result of that in the entire Western world's financial system. I think if we look at the firms that have done well over the last 8 weeks, they came into this position with portfolios of both credit risk and equity market risk that could tolerate extreme moves, which we have witnessed. And they have come into this crisis with very solid financing lines, which have been important in terms of weathering the storm that we have just gone through.

Mr. Towns.

Mr. Soros. What was your question? I didn't fully understand your question. Was it how it affected our----

Mr. Towns. Yes. How you seemed to have been able to anticipate when others were not able to anticipate, especially Wall Street and Washington.

Mr. Soros. I fully anticipated the worst financial crisis since the 1930's. But frankly, what has happened in the last 8 weeks exceeded my expectations. The fact that Lehman Brothers was allowed to go declare bankruptcy in a disorderly way really caused a meltdown, a genuine meltdown of the financial system, a cardiac arrest. And the authorities have been involved since then in resuscitating the system. But it has been a tremendous shock, the impact of which has not yet been fully felt. Now, as far as my own fund is concerned, I came out of retirement to preserve my capital, and I have succeeded in doing that. So we are flat for the year, because by taking the necessary steps I was able to counterbalance the losses that we would be suffering otherwise, which would be quite substantial.

Mr. Towns. Thank you very much. Thank all of you for your answers. The gentleman from Indiana.

Mr. Souder. Thank you, Mr. Chairman. And I understand this is a financial hearing, and I am not going to get into other questions, but I just want to say, Mr. Soros, we have had deep disagreements over the years on the heroin needles promotions and your promotion of different what I believe are back-door legalization of marijuana. And I believe while you have done humanitarian efforts around the world, your intervention in the drug area has been appalling. And I haven't had the chance to talk to you directly, and I wanted to say that because I believe it has damaged many Americans. And I hope you will reevaluate where you put your money. But I do have a question directly to you on your question on equilibrium, that don't hedge funds provide some of that equilibrium by buying long and selling short and going after companies that haven't been responsible? And why do you think there wasn't more of that in this case?

Mr. Soros. Well, to some extent hedge funds do. And of course we shouldn't put all the hedge funds in one category. There are different strategies and they have different effects. And definitely selling short is a stabilizing factor, generally speaking, in the market. In other words, the markets that allow and facilitate short selling tend to be more stable than those that prohibit them. At the same time, hedge funds do use leverage. And leverage by its very nature has the potential of being destabilizing, because as the market goes up the value of the collateral increases, you can borrow more, and also maybe since you are making profits your appetite for borrowing more is increasing. So there is greater willingness to lend by the banks. So this is the--generally speaking, bubbles always involve credit. And since hedge funds use credit, they are contributors to the bubbles. It is nothing specific to hedge funds, it relates to everyone who uses credit.

Mr. Souder. Mr. Paulson, you said a little bit ago that you felt that the government needed to get more involved in the fact that some use too much leverage, and that it is kind of a slippery slope because, as Mr. Soros just suggested, that in fact hedge funds use some leverage as well, and in fact while you serve a function for equilibrium, you often exaggerate the extremes of that through selling short or buying long. Could you respond some to what Mr. Soros said? How do you feel? Do you still feel you shouldn't have additional regulation with that? And how do you respond to the fact that you do in fact exaggerate some of these trends?

Mr. Paulson. Well, I think what leverage does is it exacerbates any move----

Mr. Soros. Yes.

Mrs. Maloney. And Mr. Simons, you also in your testimony made a similar statement about transparency and appropriate regulation. So would you agree also that it is correct to have more----

Mr. Simons. Yep.

Mr. Soros. I think earned income should be taxed as earned income. If you have a partnership arrangement and you--and that allows you to take capital gains and you want to change that, I think that would be appropriate. It would be inappropriate to-- --

Mr. Shays. Let me just cut you off, Mr. Soros, because you have all answered the question. Do you all agree with or disagree with----

Mr. Soros. I am in agreement with it being taxed as earned income. But I would take exception if this was only applied to hedge funds, and not other forms of partnership.

Mr. Shays. I am sorry. I thank you for finishing the answer. Do any of you disagree with that answer?

Mr. Falcone. I disagree to a certain extent. I think that hedge funds shouldn't be looked at differently. And it is really a function of the underlying asset. If you have an asset and you hold it for longer than 12 months, then you should be subject to capital gains tax like any other individual or real estate partnership or any investor.

Mr. Soros. Exactly in order to avoid this kind of conflict of interest, I only have one fund and all my assets are in that fund.

Mr. Shays. I see. Has that fund done better or worse than your other funds?

Mr. Soros. There is no comparison. It is the only one.

Mr. Shays. I am sorry, you just have one fund. I am sorry. Thank you.

Mr. Simons. OK. Well, no, I have----

Mr. Soros. I do.

Mr. Cummings. I can't hear you.

Mr. Soros. I agree to it. I have no problem with it.

Mr. Cummings.

Mr. Soros. I am sorry, I didn't follow the question properly. I am sorry.

Mr. Tierney. In my old business we used to be able to have it read back. Do you agree with Mr. Paulson that as long as taxpayers' money is being given to these institutions for the purposes of thawing out the so-called credit freeze that we ought to be getting a better deal for the taxpayers? We ought to be getting better security for that investment? We ought to be making sure that the banks or the entities are not giving excessive compensation with it, bonuses and things of that nature, and are not giving cash dividends while the stockholders, the taxpayers' money is there?

Mr. Soros. I am not sure that I would agree with Mr. Paulson on that.

Mr. Tierney. Why not?

Mr. Soros. I think that if you have a capital increase in the banks, then I think that as long as the money is put up by the shareholders, there should be no change in the--it is up to the shareholders how they compensate.

Mr. Tierney. But this is taxpayer money, not shareholders' money we are talking about.

Mr. Soros. When it is taxpayers' money, no, that I agree. Yes. Yes.

Mr. Tierney. Thank you. Mr. Simons, do you also agree?

Mr. Simons. Generally speaking I do, although I will make the point that when this first round of money was put into these banks some of them didn't want to take it. And then Paulson said everyone has to take it. And therefore, if you are going to--because he didn't want the public to distinguish which bank is stronger and which bank is weaker or so on, which maybe was a good idea, maybe wasn't. But the result is that everyone had to take it. And if you have to take it, well, then you can mitigate that a little bit by saying, OK, I won't gouge you too much or whatever it would be. So I am not saying the 10 percent is gouging, by the way, but some of this money was not requested by some of these banks. To the extent that it was, I think it was quite a sweet deal.

Mr. Soros. I am definitely at a loss because it is not a subject that I have really given a lot of thought to.

Mr. Yarmuth. Chairman Waxman excused you.

Mr. Soros. I think that hedge funds, several hedge funds have claimed to follow a market neutral strategy exactly because institutional investors want to see low volatility, and I think that was rather misleading. I don't think it was deliberately misleading, but actually because there is this false paradigm that has prevailed, that has pervaded the thinking on this subject, people thought that they were market neutral, and in actual fact when an event occurred that was not a random fluctuation or deviation, then it turned out to be non-market neutral.

Mr. Cooper. Thank you. You mentioned that investors usually want low volatility. The markets have been unusually volatile recently, and some trading strategies depend on volatility. How much volatility is enough?

Mr. Soros. Well, see----

Mr. Cooper. 200 points a day, 500 points a day, a thousand is more better? Mr. Soros [continuing]. Basically, what the prevailing paradigm has neglected is the uncertainty that is connected with this reflexive connection. We have become very adept in calculating risk. And by focusing on risk, we have left out uncertainty. And that has been our undoing in this particular case.

Mr. Cooper. How about the other panelists? Is a volatility only strategy appropriate? And if so, is more volatility always better?

Mr. Soros. Well, you see, I think volatility is an indication of uncertainty. And the fact that normal volatility is 30, and it shot up to 50 and 70 and 80, it just shows the increased uncertainty that is currently pervading the markets.

Mr. Cooper. Does the government have a role in limiting excessive uncertainty?

Mr. Soros. Well, I think that regulators have to understand that there is this uncertainty in markets. And that is why the risk management methods used by individual participants who are only thinking of their own risk is not appropriate in calculating systemic risk. And to protect against systemic risk, you have to impose restrictions on the amount of credit or leverage market participants can use. That is actually the core of my argument that I am putting forward.

Mr. Griffin. Congressman Cooper, if I may.

Mr. Cooper. Yes.

Mr. Simons. Yes.

Mr. Falcone. Yes. Mr. Van Hollen. Now, we had just before you a panel of a number of professors, including Professor Lo and

Mr. Soros. Well, I would definitely argue that is exactly what you need. That is what currently is missing and it needs to be introduced. We used to have that kind of authority. In earlier years, in my youth I used to be aware of them. They have fallen into disuse. And I think they have to be brought back, because there is a distinction between money and credit, and markets don't tend toward equilibrium, and it is the job of the regulators to prevent asset bubbles from developing.

Mr. Paulson. I would agree with that.

Mr. Soros. Well, certainly the introduction of newfangled financial instruments has made it much harder to calculate leverage because some of those instruments are leveraged instruments. So, given all the derivatives that have been introduced, calculating the leverage becomes a very, very complicated problem. And especially if you have tailor-made instruments, then it becomes even more difficult. So I think that it may be necessary to actually--while it is certainly necessary for the regulators to understand what they are regulating, and if they don't, they should perhaps not allow some of those instruments to be used. So I think that the instruments themselves would have to be authorized, approved by the SEC, or whatever, before they could be used.