In all of the American Insurance Group (AIG) upheaval, the greatest lesson has been ignored, according to prominent Wall Street financier George Soros, who attributes the failure of the insurance giant to what he labels toxic credit default swaps.
Soros, the chairman of Soros Fund Management, wrote in an opinion piece in Tuesday’s Wall Street Journal that these financial instruments must be highly regulated in order to alleviate some of the destruction they have caused in the credit crisis.
“What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them,” advised Soros in the piece.
Soros, author of The Crash of 2008, attributed AIG’s failure to an over-buying of CDS without the implementation of proper precautionary measures.
“AIG failed because it sold large amounts of credit default swaps [CDS] without properly offsetting or covering their positions.”
Credit default swaps are contracts intended to provide a type of insurance against complex debt securities in case of default -- which occurs when the debtor is unable to make required payments on the bond.
While alleviating risk and ensuring financial security to buyers, the financial instrument simultaneously guarantees the creditworthiness of debtors, so ideally, the seller is obligated to compensate the buyer for losses incurred under default.
Many market observers say that a problem with CDS, which were invented on Wall Street in the 1990s and swelled the market in the early 2000s, is that they have been completely unregulated.
Before the global credit crisis unfolded, swap issuers were required to post collateral as a hedge against default -- but due to the lack of regulation, collateral deposits were often too small to cover losses as the financial markets sank into recession.
The Federal government originally bailed AIG out in September because it had defaulted on its CDS and could not afford the subsequent loss payments. The company continues to suffer losses, and taxpayers are on the hook for $180 billion or more in bailouts to the company.
Soros’ Plan
The traditional view of market behavior asserts that market prices reflect all current and known information -- but Soros asserted that markets actually reflect future anticipation rather than current knowledge.
In order to tackle this new market view, he came up with a “new paradigm” that recognizes the “poisonous nature of CDS” in a “three-step argument” that helps to prove, according to Soros, that the leading downtrodden banks such as AIG and Lehman Brothers were “destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other.”
AIG failed, according to Soros, because it did not understand the above argument.
In order to fix the damages that CDS have incurred, Soros said that they should be completely removed from trading on regulated exchanges and should only be handled by the bond owners themselves.
Soros asserts that his paradigm would end up saving the U.S. Treasury a lot of money.
“Under this rule the buying pressure on CDS would greatly diminish and all outstanding CDS would drop in price. As a collateral benefit, the U.S. Treasury would save a great deal of money on its exposure to AIG.”
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