George Soros weighed in on derivatives and financial system regulation during a trip to China. He didn’t pull any punches on either subject. He has scant use for derivatives in general and believes credit default swaps are “instruments of destruction” that need to be outlawed.

From Reuters:

He said one financial institution that discovered to its cost the risk/reward distortions of CDS was insurer American International Group (AIG.N), which was a big seller of CDS, offering banks protection against a deterioration in their bond portfolios, especially mortgage-linked securities.

The U.S. government stepped in to save AIG from collapse under bad mortgage bets last September, and has put up to $180 billion at the company’s disposal since.

“AIG thought it was selling insurance on bonds and as such CDS were outrageously overpriced. In fact AIG was selling bear market warrants and it severely underestimated their value,” Soros said.

At this point, the phenomenon that Soros describes as reflexivity kicked in. That is to say, the mispricing of financial instruments — in this case, CDS — affected the fundamentals that the prices were supposed to reflect.

Now here were the consequences of the ensuing chain reaction more severe than in the case of financial institutions, whose ability to do business depended on trust, Soros argued. He cited the failures of Bear Stearns and Lehman Brothers.

But the potential damage that CDS could do was not limited to financial firms, Soros added. He pointed to the bankruptcy of North America’s largest newsprint maker, AbitibiBowater Inc (ABWTQ.PK), and the pending bankruptcy of General Motors (GM.N)

In both cases, some bondholders owned CDS and they stood to gain more by bankruptcy than by reorganisation.

“It’s like buying life insurance on someone else’s life and owning a license to kill,” he concluded.

Soros’ criticism echoes fellow investor Warren Buffet’s description of derivatives in 2003 as “financial weapons of mass destruction”.

On derivatives in general, Soros said they should be as strictly regulated as stocks.

He said derivatives should be standardised and saw no case for custom-made derivatives, which he said only increased the profit margins of the financiers who tailored them.

I think the case for CDS enhancing the potential for bankruptcies has yet to be made but I do agree with his point about custom made derivatives. They take the game too far.

On regulation, The Telegraph reports these comments:

Although warning against the tendency to over-regulate markets in the wake of the crisis, Mr Soros proposed three principles that should guide regulators as they seek to build systems that will prevent a repetition of events.

Firstly, regulators must overcome their previous tendencies to what Mr Soros called ‘market fundamentalism’ and take responsibility for identifying and correcting asset, credit and equity bubbles before they caused undue damage.

He acknowledged that regulators must accept this assignment “knowing full well that they are bound to get it wrong” but that once engaged in the process they would learn from their mistakes and get better through a ‘process of trial and error’.

Secondly Mr Soros argued for flexible credit controls that would react to market mood-swings, requiring, for example, requiring mortgage lenders to adjust loan-to-value ratios on residential mortgages in order to forestall property bubbles.

Mr Soros cited the 2001 dotcom equities bubble as an example of where, in his vision for a re-regulated global financial system, regulators would have stepped in to cool the market by freezing new share issues.

Lastly Mr Soros said that the practice of securitizing bank assets had greatly added to systemic risk and must now come under tighter controls, including requiring banks to limit proprietary trading to their own assets in order to protect depositors.

“Banks must use less leveraging and accept risk on their investments, they should not be allowed to speculate on their own account with other people’s money,” he added.

“This may push proprietary trading out of banks and into hedge funds which is probably where they belong.”

There’s an awful lot of command and control embedded in those suggestions. I think the general thrust of his ideas is OK but they assume a level of knowledge and certainty that I doubt anyone least of all a regulator possesses. Practically, I don’t see them working in the U.S. since Congress squeals when the Fed tries to take the punch bowl away via monetary policy. Think how they might react if a regulator directly choked off a market.