Soros Joins Paulson Saying Fed Did Too Little to Prevent Financial Crisis

Date: Friday, February 11, 2011
Author: Katherine Burton, Saijel Kishan and Gillian Wee, Bloomberg

George Soros and John Paulson, who oversee two of the world’s largest hedge funds, say the Federal Reserve helped cause the financial crisis through inaction and lack of oversight, according to interviews released yesterday.

Paulson, whose Paulson & Co. made $15 billion betting against subprime mortgages in 2007, said better supervision of home loans by the central bank would have helped prevent the crisis. Soros, chairman of the $27 billion Soros Fund Management LLC, said the Fed should have saved Lehman Brothers Holdings Inc. from collapse in 2008. Both men were interviewed by the Financial Crisis Inquiry Commission in October.

Soros, 80, and Paulson, 55, weren’t the only traders interviewed by the commission to lay some of the blame for the 2008 crisis on the Fed and Alan Greenspan, its former chairman. Greenspan, who headed the U.S. central bank for almost 19 years before retiring in 2006, was heralded for keeping economic growth steady and inflation low when he stepped down. Since then, criticism of his policies has grown.

Greenspan “allowed, and in some sense encouraged, the extraordinary excesses of the period,” said Michael Steinhardt, 70, another interviewee and a hedge-fund industry pioneer. “It was like the pope blessing the things that went on in World War II. You depend on certain people to be your moral police and that’s what he was, and he didn’t act appropriately.”

The Fed did “very little” to oversee mortgage underwriting from 2000 to 2006, Paulson said.

“Demanding that proper underwriting guidelines be followed, not allowing ‘no doc’ loans, requiring a down payment, even if it’s just 5 percent,” would have gone a long way toward preventing the crisis, he said.

‘False’ Market Theories

The crisis was avoidable, according to Soros.

“It’s the theories adopted by both the regulators and the market participants that proved to be false,” Soros told the panel. “It’s the efficient-market hypothesis and the rational expectations theory.”

The efficient-market hypothesis holds that prices reflect all relevant information available to market participants. Under the rational expectations theory, people make decisions based on their rational outlook while influenced by past experiences.

The Fed should have stepped in to rescue Lehman before the investment bank went bankrupt, he said.

“I don’t think Lehman should have been allowed to fail,” Soros said. “The Fed, in my opinion, has very wide discretionary powers which were not used.”

‘Best We Could’

Congress created the commission to investigate the causes of the crisis, which triggered the failure of Lehman Brothers Holdings Inc. and led to government bailouts of insurer American International Group Inc. and other financial companies.

Last April, Greenspan said the central bank under his leadership made mistakes while attempting to ensure the sound regulation of financial institutions.

“What we tried to do was the best we could with the data that we had,” Greenspan told the commission in Washington. “Did we make mistakes? Of course we made mistakes. I know of no way that can be altered under the existing structure.”

Greenspan didn’t respond to a call seeking comment after regular business hours yesterday at his Washington-based consulting firm, Greenspan Associates LLC.

To contact the reporter on this story: Katherine Burton in New York at kburton@bloomberg.net.; Saijel Kishan in New York at skishan@bloomberg.net; Gillian Wee in New York at gwee3@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net.