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« Obama and Democrats Try To Sneak $100 Billion Stealth Bailout To European Banks | Main | The Solution To Urban Blight And Abandoned Homes: A Caterpillar »
Sunday
Jun142009

George Soros Says "Credit Default Swaps Are Instruments Of (Financial) Destruction And Should Be Outlawed"

George Soros

See also:

SNL Sketch On The Bailouts With Soros, Pelosi and Barney Frank

Legendary currency trader (Pound destroyer) and hedge fund manager, Geroge Soros still has a big, brass set.  Speaking yesterday to the Institute for International Finance in Beijing, whose members are huge players in the trillion dollar CDS market, Soros said: "CDS are instruments of [financial] destruction and ought to be outlawed."  It's pretty hilarious that Soros delivered this opinion to a crowd hostile to his ideas, in what likely was a paid speech for the IIF.

Other quotes of note:

"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."

"People buy a CDS not because they expect an eventual default but because they expect them to appreciate in response to adverse developments."

"It's like buying life insurance on someone else's life and owning a license to kill."

"Bondholders owning CDS stand to gain more by bankruptcy than by reorganisation."

From Reuters:

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 realised 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.

This asymmetry, which encouraged investors in effect to sell corporate bonds short, was reinforced by the fact that CDS were traded and so tended to be priced as warrants, which could be sold at any time, and not as options, he added.

Credit default swaps are used to protect against nonpayment of debt or to speculate on a company's credit quality.

But Soros said: "People buy a CDS not because they expect an eventual default but because they expect them to appreciate in response to adverse developments."

SKEWED INCENTIVES

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.

The U.S. government stepped in to save AIG from collapse under bad mortgage bets last September, and has put up to $180 billion at the company's disposal since.

"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.

At this point, the phenomenon that Soros describes as reflexivity kicked in. That is to say, the mispricing of financial instruments -- in this case, CDS -- affected the fundamentals that the prices were supposed to reflect.

Nowhere were the consequences of the ensuing chain reaction more severe than in the case of financial institutions, whose ability to do business depended on trust, Soros argued. He cited the failures of Bear Stearns and Lehman Brothers.

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, and the pending bankruptcy of General Motors.

"In both cases, some bondholders owned CDS and they stood to gain more by bankruptcy than by reorganisation.

"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 standardised and saw no case for custom-made derivatives, which he said only increased the profit margins of the financiers who tailored them.

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Reader Comments (4)

Hmmm, nice of Soros to notice this fact AFTER the damage was done. It makes him neither genius nor humanitarian in my book.

I wonder how much he made off of CDSs before saying it's time to close 'em down.
Jun 14, 2009 at 11:59 AM | Unregistered CommenterSonic Ninja Kitty
Sonic Kitty.

Actually, if you read the piece, and others from Soros over the past year, he knew nothing about CDS. He is a newcomer to this arena. He even says in the Reuters article that as he learns more about them he believes they should be outlawed.

He is a currency guy who plays in equities now. I doubt he has much use for CDS. As always, thanks for commenting. And I hope you saw my response to you that one day about the Dalai Lama. I clarified my thoughts a bit in that post.
Jun 14, 2009 at 5:05 PM | Registered CommenterDailyBail
DB...you may need a new site when the bank failures really get up some steam. Maybe the "Daily Fail".......Banker Motto: "You don't look good ......unless.....WE...look good"
Jun 14, 2009 at 6:58 PM | Unregistered CommenterAin't Bullshittin'
Hi Daily Bail, Yep, I did see the response--thanks for the clarification. It's nice to chat about those things once in awhile. Keeps you balanced :)
Jun 16, 2009 at 12:12 AM | Unregistered CommenterSonic Ninja Kitty

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