AIG was insuring mark-to-market risk rather than default risk which is where they went wrong.

TO BE NOTED: From A Credit Trader:

"Soros: Kill, kill, kill the CDS

In his latest WSJ post, Soros outlines why he thinks “naked shorting” i.e. buying of CDS without a bond position should be banned.

My commentary to his points are in italics below:

• AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. Perhaps I’m reading in too much into this sentence but to expect AIG to somehow have hedged or offset its CDS trades is akin to an insurance company kidnapping sick people who have bought life insurance and sticking them in incubators to prolong their life. AIG sold protection because it viewed selling CDS as an insurance business. The oft-uttered phrase that AIG was a hedge fund are missing the point that these trades were buy-and-hold; AIG was not in the business, unlike a hedge fund, of dynamically trading in the market.
• What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated. I like when the conclusion is stated upfront without any salient points.
• It [heavily regulating CDS] would also save the U.S. Treasury a lot of money by reducing the loss on AIG’s outstanding positions without abrogating any contracts. In fact, the US Treasury had three options in dealing with AIG’s trades: 1) take over AIG and have AIG’s counterparties face the government, 2) post enough cash to cover AIG’s collateral calls, 3) unwind AIG’s trades. It chose 3 which I think is the worst option as a) it locks in massive losses, b) it does so at the absolute wides of the market (spreads naturally blew out as soon as the market realized AIG was in big trouble), c) it commits the most amount of cash upfront.
• Since they [CDS] are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. CDS can be used as easily to go long risk as short risk. In fact, for each nefarious speculator betting on the demise of the poor company by buying protection, there is an avenging angel who is sitting on the other side of the trade and is a seller of protection. While, it is true that there can be heavy one-way flow in CDS on the back of strong protection buying or selling which will drive the market in one direction, the dealers obviously adjust the CDS levels up or down based on this flow at which they are happy to take the other side of the trade.
• Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. “Reflexivity” strikes again. I don’t think it has ever been news that the prices of assets affect investor psychology which will, in turn, have an effect on the prices of financial assets. This is certainly true of all other assets including CDS.
• Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. If the CDS product payoff profile is so skewed in favor of buyers of protection, why did credit spreads rally for many years until 2008. Also, if the average price of a high yield bond is in the 50s vs. an average historic recovery (yes recoveries in this cycle will be lower) of 40 – that suggests that the payoff profile is in favor of protection sellers, not buyers. Finally, gamma is on the side of protection sellers as well as duration increases as spreads rally – in other words, a protection buyer makes less marginal dollars for each basis point of widening in spreads since risky duration goes down. This can be seen via the Merton debt/equity model as well. Also, for distressed names, protection tends to be priced upfront which means that buying protection in expectation of a quick default is actually quite expensive.
• People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. I don’t understand what is wrong with this. If the risk of default increases, protection should be more expensive. That’s called a fair market.
• 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 was insuring mark-to-market risk rather than default risk which is where they went wrong.
• A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating. Lehman went bust largely because it could not raise short-term funding, not because of any CDS pressure. A rating downgrade caused the stock price to fall, making it difficult for Lehman to raise enough cash by issuing equity which caused rating agencies to downgrade it further, leading…. Also, Morgan Stanley CDS traded wider than Bear or Lehman and yet it miraculously survived. I guess reflexivity is only invoked when it works, kind of like those technical indicators.
• I believe that they [CDS] are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. What is wrong with speculation as such? Should we ban short-selling in stocks forever and ever? Metalgesellschaft lost a lot of money on commodities and Orange county on moves in interest rates. Let’s ban those as well. Also, reading this sentence suggests that CDS can only be by those who hold bonds. So, will sellers of protection be required to hold bonds as well. I’m sure this is not what Soros meant, just thought I’d be cheeky."