Soros Doesn’t Understand CDS

A friend of mine once pointed out to me, years ago, that Warren Buffet was an investor in Dairy Queen. I replied, “Warren may know a lot about stocks, but he doesn’t know $#% about food!”

As the man who broke the pound, multi-billionaire George Soros obviously has nothing to fear from me. His editorial on the WSJ, however, makes it clear he doesn’t understand CDS.

A couple thoughts:

• What about IRS? If George has problems with CDS, it seems he should be even more concerned with the interest rate swap market. I don’t know exactly how large it is, but I imagine it’s at least an order of magnitude larger than the credit default swap market.
• Asymmetric Risks? George argues that asymmetric risk profiles promote the shorting of credit risk and speculation. Yet he ignores the fact that AIG got into trouble because it established massively LONG credit risk positions by selling protection during one of the tightest spread environments in history. How then, could one argue that “CDS [was] outrageously overpriced?” Anyone who has done even the most cursory research on CDS understands that the investor is long credit risk when selling protection. That’s why they are called synthetics. You can synthesize/approximate a long bond postion by buying Treasuries and selling credit protection. Furthermore, AIG sold protection on structured products/tranches, not individual corporate names (directly, at least). Single name CDS is governed by standard ISDA agreements and collateral requirements.

I place the blame for AIGs predicament squarely on the executives involved, risk management, and the senior management of the firm. Clearly, those directly responsible were gaming the system and AIG’s rating. Nevertheless, risk management, accountants, and senior management didn’t have to know anything about correlation or complicated structures to recognize AIG was long billions of dollars of unhedged credit risk. That’s what’s most infuriating to me.

It’s also infuriating that some people equate CDS contracts with irresponsible casino gambling because you don’t own the underlying asset. Let’s make this clear: If you own an ETF, trade equity options, or even buy coupons online, you are dealing with derivatives!Even ‘complicated’ index tranches can be described as call spreads on porfolio loss (see the previous post on Delta and Mark To Market).