The solution to credit default swaps (CDS), the complicated derivatives that brought AIG to its knees, is tighter regulation, says hedge fund icon George Soros.
In a Wall Street Journal opinion piece, Soros writes that the most important lesson of AIG's demise has been ignored.
"AIG failed because it sold large amounts of CDS without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated."
CDS are used to hedge against the risk that bonds will default. Only investors who actually own the underlying bonds should be allowed to buy CDS, Soros argues.
"Instituting this rule would tame a destructive force and cut the price of the swaps," he says.
"It would also save the U.S. Treasury a lot of money by reducing the loss on AIG's outstanding positions without abrogating any contracts."
While some maintain that CDS should trade on regulated exchanges, Soros thinks that doesn't go far enough because all kinds of speculators would be able to bet on them.
"I believe that they are toxic and should only be allowed to be used by those who own the bonds," he says.
Soros may have an ally in the Obama administration. Treasury Secretary Tim Geithner said at a conference Monday that the administration will work with Congress to overhaul the financial regulatory system.
Our system "was too fragile," Geithner said.
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