CDS

I promised to follow up on CDS a few weeks ago, but got sidetracked by the hoopla of the market recently. The point I wanted to make is as follows. The notional value (the amount outstanding) of CDS on an individual company (credit) usually far exceeds the amount of bonds that company has outstanding, certainly for credits that might require insurance. So when a default occurs, you, as the bond holder, would go to the credit default swap counterparty and say, "Here are $10mm face amount of bonds, give me my $10,000,000." The problem occurs when there aren't enough bonds to tender into the swaps, creating a short squeeze. Although unlikely, it is conceivable that the bonds could be worth more after a default than before, as market participants scramble to get their hands on bonds. Before the recent turmoil, hedge funds traded individual CDS to get exposure, long or short, to a credit because the CDS market was more liquid than the cash bonds, could be done with less capital (i.e. more leverage), and didn't require the fund to go out and borrow securities, in the case of a short position (there are a host of other reasons, not worth going into).

The problem is that is market is relatively new and hasn't been tested significantly in a stressed market. So far, no significant credit has defaulted. When (not if) that happens, it is only then we will see the true extent of the problems in the current market.

In the end, it is important to remember that not every investor or investing entity was engaged in risky, questionable, or highly leveraged strategies (that is just what you hear about). This isn't 1929, the markets will right themselves, the foolish will get punished (until the next hot idea) and we'll all be better for it in the end.