George Soros, the billionaire hedge fund manager, called for credit default swaps to be banned, saying these financial instruments had the potential to wreck individual companies and to bring down the banking system.
CDSs were designed as insurance against a company defaulting on its debt, but have grown into a multi-trillion dollar market that allows investors to speculate on a companies’ improving or deteriorating creditworthiness.
The huge CDS profits that could be made if a company really does default on its debt are encouraging bondholders to put companies into bankruptcy rather than restructure their debts, Mr Soros told a meeting of the Institute of International Finance in Beijing.
“It’s like buying life insurance on someone else's life and owning a licence to kill,” he said.
The US government is proposing new regulation of the CDS market, including standardising the products so that they can be traded on an exchange, but Mr Soros went much further in his criticisms, saying they were “instruments of destruction” that should be outlawed entirely.
Disruptions in the CDS market, which might make it more expensive to insure a companies’ debt, can then feed back into perceptions of the company’s creditworthiness. 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, Mr Soros argued.
The CDS market is so large and so interconnected with the rest of the capital markets that its biggest player, the insurer AIG, had to be nationalised by the US government during last year’s financial panic, for fear of the consequences if it had gone under.
“AIG thought it was selling insurance on bonds and as such CDS were outrageously overpriced,” Mr Soros said. “In fact AIG was selling bear market warrants and it severely underestimated their value.”