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BEIJING, June 12 (Reuters) - Credit default swaps are "instruments of destruction" that should be outlawed, billionaire investor George Soros said on Friday.
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."
He said one financial institution that discovered to its cost the risk/reward distortions of CDS was insurer American International Group (AIG.N), 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 Inc ABWTQ.PK, and the pending bankruptcy of General Motors (GM.N)
"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.
(Reporting by Alan Wheatley; Editing by Chris Lewis)