Soros wants to ban credit default swaps. Is he blaming a cause or a symptom?
It's no great secret that George Soros is not a fan of credit default swaps. "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 realized they're truly toxic," the hedge-fund manager and political activist recently told attendees at an international banking conference. "CDS are instruments of destruction which ought to be outlawed."
Soros's exhibit A: American International Group (AIG), which sold CDS worth hundreds of billions in notional value, and which, when demands for collateral overwhelmed its ability to pay, was forced to accept a humiliating government rescue package last fall.
Soros argued that the asymmetry inherent in CDS transactions made their trade dangerous. Selling a CDS is a bet that a company's perceived creditworthiness will remain solid. It's similar to selling an equity put option -- the seller collects a small premium upfront but may have to make a large payout in the future should things go wrong.
But are credit default swaps inherently dangerous? Or were they simply mishandled by those trading them -- not a cause but a symptom of the problematic incentives governing the world of finance? My colleague Joseph Lazzaro has taken an economist's view of the problem, arguing that CDS need to be regulated because they create systemic risk. I think there's another angle here, which is that CDS were simply what exposed distorted regulations this time around.
Let's start with accounting. What is a credit default swap? Conceptually, selling a credit default swap is the same as owning a bond from the company the CDS is written on: as long as the company is paying its debt, the CDS seller is in good shape. But CDS sellers do not record assets on their books, as a bond seller would.
Is selling a CDS more like insurance? Not in the sense that when insurance companies write off business, they record a loss reserve. CDS sellers don't do this either. As has been demonstrated before, off-balance-sheet accounting is murky, and when it hides a liability, it's dangerous.
Problems begin to appear when the contracts are marked to market. If the position deteriorates, the CDS seller records a non-cash GAAP loss. With the volatility in markets in 2008 and 2009, and the leverage employed in writing CDS, this can quickly translate to multibillion-dollar swings. Many CDS sellers, though, had AAA counterparty ratings from the ratings agencies, and this allowed them to escape without posting collateral.
What took down insurer-turned-hedge-fund AIG was that, because the step beyond being a AAA counterparty was never considered, a downgrade could cripple the firm, turning unrealized mark-to-market losses into losses that needed to be met with collateral the company didn't have. In AIG's case, a firm mismanaged its liquidity and risk positions. That doesn't mean the derivative is evil.
Another hotly debated point is that a bondholder owning a CDS creates moral hazard when a firm is on the brink and needs to restructure. Because they are protected from a loss, the bondholders have no incentive to bargain and take a reduced stake to save the company. The simple solution to that, of course, is to offset the voting rights of the bondholder by granting them to the party actually taking the risk -- the seller of the CDS. That's a reasonable adjustment that aligns economic incentives, and hopefully when reform comes to the CDS market, that will be one aspect addressed.
In his speech, George Soros also cited Bear Stearns and Lehman Brothers as institutions hurt by the ability of CDS to reflect negatively on their creditworthiness, creating a "bear raid," a run on the bank. Again, in this case, the CDS market was more a symptom of an underlying problem -- inadequate liquid capital, too much leverage -- than the cause of the problem itself.
At the most basic level, CDS have been reflecting many of the problems financial companies had going into the crisis: hidden liabilities, too much short-term financing (and thinking), and excessive leverage. Yes, some changes would make sense -- CDS could be standardized, their ratings-dependent triggers eliminated -- but regulations should not ignore the underlying problem to focus on the symptoms.
Would Soros back off his comment that CDS should be banned, in favor of more measured regulatory oversight in areas such as risk management? A Soros spokesman says this is unlikely, because methods of risk management favored by Wall Street "[do not] allow for uncertainty -- which by its nature cannot be quantified and taken into account."