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BEIJING, June 12 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,"
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
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)