GM mentioned many valid points, but she misses out that the tail wags the dog in CDS world for so long. I became well aware of that process when trading defaulted bonds in and out of CDS settlements.
All happened when the CDS protocol was changed to "cash settlement", from physical delivery. As in fire insurance: I actually don´t need to own the house which is set on fire. It could be the neighbours or the ex spouses house. Or, I don´t need to turn over the wreck any more; all I need is to show a photograph of the car...
Said that, while cash settlement resolved the problem of inefficient defaulted bond prices (which were sometimes too high going in a settlement), it opened the real can of worms. Derivative bets on the default and ultimate settlement prices can reach an high multiple of the default in question, as if a thousand similar houses would burn.
Again, in insurance world, there is no such thing as "overinsurance". But again, in C.D.S world, there is. Enter Dura, which became one of the first cash settled CDSs. At the time of the default, an estimated 12 times the bond notional in bets riding, with the low price (20 or so) creating a huge incentive to move the settlement price into the right direction.
Which did. After some months, with Dura not getting any better, the price of the senior issue nearly tripled (reaching the expected recovery value). |
