Hussman Ties It All Together

In his latest market commentary ("On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases"), Dr. Hussman lucidly recaps his previous objections to the government's responses to the financial crisis and offers alternative solutions. On the issue of credit default swaps, Hussman writes that the government ought to,

[L]egislate a restriction on the use of credit default swaps (essentially insurance contracts against the failure of a company's bonds), requiring that such swaps may be used for bona-fide hedging purposes only. That is, a credit default swap could not be entered for purely speculative purposes, but only to offset the default risk of the same or similar bonds held by the investor.

This is similar to George Soros's recent comments on credit default swaps (e.g., in this Wall Street Journal op/ed last week, "One Way to Stop Bear Raids"), and it's consistent with the long-standing doctrine in the insurance business that only those with an "insurable interest" (i.e., something to lose if something bad happens to the insured) are allowed to take out insurance policies¹. This reduces the chance that a policy holder will try to deliberately damage the insured in order to collect on the insurance policy.

Hussman covers a lot more ground in this week's commentary, and his essay is worth reading in full.

¹In the early days of the insurance business, this doctrine wasn't in force, and it was possible to, for example, take out a life insurance policy on a complete stranger, despite the perverse incentives that would create.

George Soros Recaps His Investment Decisions in 2008

From a sidebar to an article by George Soros in yesterday's Financial Times about the financial crisis ("The Game Changer"), a self-assessment by the billionaire investor:

THE SOROS INVESTMENT YEAR:

Positions I took were too big for ever more volatile markets

Although I positioned myself reasonably well for what was coming last year, one thing I got wrong cost me dearly: there was no decoupling between markets of the developed and developing worlds.

Indian and Chinese stocks were hit even harder than those in the US and Europe. Since we did not reduce our exposure, we lost more money in India than we had made the year before. Our Chinese manager did better by his stock selection; we were also helped by the appreciation of the renminbi.

I had to push very hard in my macro-account to offset both these losses and those incurred by our external managers. This had its own drawback: I overtraded. The positions I took were too large for the increasingly volatile markets and, in order to manage my risk, I could not go against the market in a big way. I had to try to catch minor moves.

That made it difficult to maintain short positions. Although I am an experienced short-seller, I got caught several times and largely missed the biggest down-draught, in October and November.

On the long side, where I stuck to my guns, I lost an enormous amount of money. I was impressed by the potential in the new deep-water oilfield in Brazil and bought a large strategic position in Petrobras, only to see it decline by 75 per cent at one point in time. We also got caught in the developing petrochemical industry in the Gulf.

We did get out of our strategic long position in CVRD, the Brazilian iron ore producer, in time for the end of the commodity bubble and shorted the other big iron ore groups. But we missed an opportunity in the commodities themselves – partly because I knew from experience how difficult it is to trade them.

I was also slow to recognise the reversal of fortune for the dollar and gave back a large portion of our profits. Under the direction of my new chief investment officer, we did make money in the UK, where we bet that short-term interest rates would decline and shorted sterling against the euro. We also made good money by going long on the credit markets after their collapse.

Eventually I understood that the strength of the dollar was due not to people choosing to hold dollars but to their inability to maintain or roll over their dollar obligations. In a very real sense the strength of the dollar, like the fever associated with sickness, was a measure of the disruption of the financial system. This insight helped me to anticipate the downturn of the dollar at the end of 2008. As a result, we ended the year almost meeting my target of 10 per cent minimum return, after spending most of the year in the red.