George Soros has written an opinion in today's WSJ calling for the regulation - and elimination - of CDS.
He notes that CDS are instruments which allow speculation on default:
What makes [CDS] toxic is that such speculation can be self-validating.
I find his nature-of-the-security argument severely lacking:
The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.
AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.
AIG underestimated their MTM risk, to be sure, but they had negotiated their MTM risk away via collateral-free counterparty agreements. In this paradigm, AIG's real downfall was their credit-rating downgrade, which forced them to post collateral. There's no question their risk management was awful, but were they not downgraded they'd still be solvent, since few of the CDS they sold have actually defaulted (and consequently mandated cashflows).
This begs an interesting question (and points out the ridiculousness of the rating agencies) -- if you have an institution which is solvent at credit rating A and insolvent at credit rating B, which one should it have?
But Soros isn't finished:
[I]t's clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other....
And AIG failed to understand this.
So let's review. A company whose "expertise" is financial products didn't understand how they work, but George Soros can explain it succinctly in a WSJ opinion. Sounds to me like the problem lies with AIG, not the CDS.
But Soros would argue that the fault for taking down massive institutions like Bear, Lehman, and AIG lies with crazy speculators, not with any failures of those firms. And we should act now to prevent these crazy individuals from taking down any more institutions, especially - say it ain't so - a government arm like the Treasury.
Now where would a timid investor like Soros get an idea like that?