My very smart friend has written up some answers to my questions, which I will repost here.
1) It did go up proportionally. It probably was 98% of the bonds worth. (I’m guessing. I don’t have the data)
2) Not naked but no one ever had the $1B dollars to pay up when the bond defaulted. It was unregulated so there are no ‘capital reserves’. People were ‘netted’ on the belief that someone had that $1B. But no one ever did. So they are all bankrupt.
1b). So it didn’t matter if the CDS premium was 98% of the bond. $1B needs to get paid out on the chain. The guy receiving the 98% premium loses 2%. But two points. Someone else is losing the rest of the 98% through the chain of netting. And 2% is on the total bond value not the capital that guy had. He’s levered. He may have lost 20% or 200% and been wiped out.
I'll tell you what I told him, which is it doesn't seem possible that this many smart people could get caught in such a web. His response:
I’m sure most of them were aware. But when you can be a multi-millionaire in one year isn’t it worth the bet? If I said tomorrow you can be worth $100M or lose your job, how many would take that offer? That’s why derivatives need to be regulated. Asymmetric returns.
When people in the industry start saying things should be regulated, that's usually a sign that it's reached absolutely critical stage.
