CDS This Way CDS That Way

Robert Waldmann

is still trying to think of creative was to use CDS to commit fraud. One key use of CDS was to relax capital controls. A debt instrument plus a CDS from AAA rated AIG counted as AAA debt, thus banks could gamble more if they bought a CDS from AIG. Would this still work if the bank sold an identical CDS to AIG ? How about a very similar CDS ?

Hmmmm. Contingent liabilities appear on published balance sheets (I mean Q-10s) at market value and without details. So on the assets side, a CDS has an effect which depends on its notional value and on the liabilities side at it’s market value.

Now I’d guess that regulators can detect and disallow regulatory benefits from positoins which exactly cancel by definition. However, different CDSs can be very close substitutes without being identical. If I buy and write CDS on similar tranches of similar pools, I am not running (or insuring) much risk. If one counts at nominal value and one at market value, can I claim that I am insuring a lot of risk ?

How about “finite reinsurance.” I’m not sure I understand everything which that phrase can indicate, but it makes me think of reinsuring risk up to a limit, so that the risk is in some sense insured, but the original risk bearer still bears the lower tail. How about I buy a CDS on a tranche of a pool and sell a CDS on an overlapping tranche of the same pool. So I am owed money if 12 to 13 % of the underlying assets default, but have bought insurance on defaults of 12 to 100% (and sold on defaults of 13 to 100%).

Goldman Sachs assures everyone that they were not vulnerable to AIG counterparty risk, because they had hedged. They have also gotten a lot of money from the US Treasury via AIG. How exactly did they hedge ? Do I need to put on my tinfoil hat to stop the Martians from beaming the idea into my brain that they might have hedged by writing CDSs for AIG that were very similar to the CDS that AIG wrote *and* which had the clause that if AIG owes Goldman Sachs then Goldman Sachs doesn’t have to pay AIG.

In cleaning up AIG liabilities were AIG assets cleaned up too ? It seems to me that there are huge opportunities for AIG-FP employees who would like to work for AIG-FP counterparties.

Do click the link. It is fascinating no matter how confused my ignorance has made me.