Soros against credit default swaps
Friday, June 12th, 2009
In an article I read, Soros called credit default swaps as instruments of destruction. Below is part of the article:Soros said the asymmetry of risk and reward embedded in CDS exerted so much downward pressure on the bonds underlying the contracts that companies and financial institutions could be brought to their knees.
“Some derivatives ought not to be allowed to be traded at all. I have in mind credit default swaps. The more I’ve heard about them, the more I’ve realized they’re truly toxic,” he told a banking conference.
“CDS are instruments of destruction which ought to be outlawed,” Soros told a meeting of the Institute of International Finance, many of whose member banks and financial institutions are active participants in the huge CDS market.
Going short on bonds by purchasing a CDS contract carried limited risk but almost unlimited profit potential. By contrast, selling CDSs offered limited profit and practically unlimited risk, Soros said.
He said one financial institution that discovered to its cost the risk/reward distortions of CDS was insurer American International Group, which was a big seller of CDS, offering banks protection against a deterioration in their bond portfolios, especially mortgage-linked securities.
“AIG thought it was selling insurance on bonds and as such CDS were outrageously overpriced. In fact AIG was selling bear market warrants and it severely underestimated their value,” Soros said.
But the potential damage that CDS could do was not limited to financial firms, Soros added. He pointed to the bankruptcy of North America’s largest newsprint maker, AbitibiBowater Inc, and the pending bankruptcy of General Motors”In both cases, some bondholders owned CDS and they stood to gain more by bankruptcy than by reorganization.
“It’s like buying life insurance on someone else’s life and owning a license to kill,” he concluded.
Soros’ criticism echoes fellow investor Warren Buffet’s description of derivatives in 2003 as “financial weapons of mass destruction.”
On derivatives in general, Soros said they should be as strictly regulated as stocks.
He said derivatives should be standardized and saw no case for custom-made derivatives, which he said only increased the profit margins of the financiers who tailored them.
