notes that some have argued that Credit Default Swap demonization is silly because they are in zero net supply so they can’t bring down the financial system (no names or links I will be rude below).
This argument is crazy.
If half the financial firms end up bankrupt and the other half make a killing the disruption will be immense. A gigantic shift from one player to another reduces the sum of their market values. This was shown back in the day by Larry Summers and David Cutler (heard of them) in “The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil Litigation,” NBER Working Papers 2418, National Bureau of Economic Research, Inc.
If the firms don’t know who is long CDS and who is short CDS they don’t know who is solvent. Such uncertainty can cause problems.
In any case, the general equilibrium literature contains a huge section on whether assets in zero net supply can make everyone worse off *If* everyone has rational expectations. The answer is yes.
The argument zero net supply so no problem is completely inconsistent with economic theory (so what) and known facts (so there) and no sensible person can possibly take it seriously.