The Iron Yuppie

Ok, I sort of get how we got to where we are in the credit markets. But after listening to an absolutely riveting hour of financial discussion on This American Life, I'm left with two questions:

1. One of the failures of the markets was the ability to use CDSs as a financial instrument without owning the underlying asset. For example, Lehman issues a bond for $100 M. MS buys the bond. MS buys a CDS from AIG on the bond for 2% of the bond’s value. Goldman, in a speculation move, also buys a CDS on the bond for 2% of the value. Then Lehman starts looking shaky – six months ago or something. More people start to buy CDSs from AIG. Why didn’t the cost of the CDS go up proportionally with the risk. For example, if it’s 1 week prior to Lehman going bankrupt, and people are freaking out about them, why wouldn’t a CDS on their bond cost 98% of the bond’s worth? The podcast seemed to indicate that it was so many people taking out CDSs on bonds that they didn’t have any relation to, purely as speculation devices. But isn’t the market supposed to handle that?
2. Another thing talked about during the podcast was the idea of netting out to hedge risk. AIG sells a CDS on Lehman’s bond to MS for 2%. Then they buy a CDS on Lehman’s bond from Wacovia for 1.98%. Then Wacovia buys a CDS on Lehman’s bond from the IMF for 2.01%. Then Wacovia goes under. The assets are still there, and the hedges are still there, correct? Meaning, yes, AIG may now take a 0.01% loss rather than a 0.02% gain… but surely they wouldn’t be considered to have a naked position, would they?
   

Anyone want to enlighten me?

D

[Update: Changed CDO to CDS as I was using the wrong acronym.]

posted by Iron Yuppie  # 10/07/2008 11:49:00 AM