[dragontamer]

Hmmm... that's a good question. Its been a while since I studied the 2008 collapse.

What I can say is that a CDS wasn't purchased directly in most cases. It was indirect.

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So for example: if you're a bank looking at a bunch of CDOs (and therefore: CDO-squared, which people didn't realize was a problem yet). You're seeing default rates creep up in 2006 and you're worried that things might collapse.

You then see a CDO that's insurance-protected. It has a lower %yield, but that's because some of the % is going towards CDS / insurance to protect your basket of mortgages. You check with the ratings agencies and they rate the bond at AAA (because even if the underlying mortgage fails, you have a big-bank providing the CDS protecting the mortgage).

You purchase the CDO (aka: buy a bunch of mortgages on the market), WITH CDS insurance. The CDS portion is sold to the highest-bidder at a separate time. The CDO-buyer didn't care "who" insured the CDO, they just wanted some kind of insurance.

That turned out to be a problem when AIG was revealed to be the owner of $500+ Billion in CDS. As such, the "insurance payout" protecting those CDOs ended up being vaporware.

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So now you're the US Government, looking at this problem. Do you let AIG collapse? If you do, all $500 Billion worth of AIG's CDSes fail (and therefore the CDOs fail). But if you let that happen, other banks also fail (and these other banks made the CORRECT decision: buying insurance to cover their ass).

This is the "Toxic Debt" problem. The toxic debt was passed from company-to-company: everyone "related" to AIG was going to be affected, and no one really had an idea of who AIG was related to.

Note: Bush let the first few banks (ex: Lehman Brothers) fail. They saw in realtime as the "toxic debt" of Lehman Brothers brought down the rest of the market.

By the time AIG was at risk, George Bush had seen enough. When one bank collapses, it causes many other banks to collapse in ways that cannot be foreseen.

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I admit that one could make the argument that it was the smaller-bank's fault for forgetting about counterparty risk (not caring who took up the other side of the CDS).

But by the time banks were falling and collapsing like dominoes in 2008, I think Bush didn't care about the morals of this particular case. It was about stopping the domino effect in general.

[arethuza]

Wasn't AIG the seller of the insurance, sorry I meant CDS? ;-)

[dragontamer]

Yes but...

Its like the Options market. You can be the seller of a call option without knowing who your counterparty is. Similarly: you don't necessarily know who the counterparty to your CDS is.

The CDS was not a standard instrument like the options market. The details of each-and-every CDS changes with each prospectus. This is very common in the bond market: bonds change (callable vs non-callable vs puttable, vs tax free vs taxed, in a CDO or CDO-squared or Synthetic CDO, or a SLAB or an MBS or... etc. etc. Lots of differing details).

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So when you buy a CDO-squared in 2006, you didn't necessarily know that AIG was providing the CDS-insurance associated with that CDO. (Hypothetically. I'm assuming that such a product existed back then...)

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If it helps, consider a $600 call option on TSLA that expires a month from now. Lets say you want to be the seller of this call option (which is a kinda-sorta insurance-like product on the price of TSLA).

You can sell this Tesla-insurance on the options market. But you will NEVER figure out who is on the buyer-side of your deal.

And vice versa: the buyer of the TSLA insurance (call option) will never know that you were the one selling that insurance. A middleman handles all the details. Neither side really cares "who" is the counterparty is, they just expect that the other side can pay up.

(In the case of options: the clearing house / middleman is a very large bank who guarantees the payment. It turns out that the middlemen of the CDS deals in 2008 were less reliable)

[arethuza]

Thanks, I had assumed that the banks organising CDSs were setting things up but the actual final transaction was directly between the two parties. So were they really in the middle selling the CDS and offloading the risk onto the likes of AIG - who was presumably thought to have zero counterparty risk?).

[dragontamer]

> who was presumably thought to have zero counterparty risk?

By my understanding: people just forgot about counterparty risk in 2008.

You have to remember: banks like Lehman Brothers have been around for over 100 years. The idea that a big bank would collapse was a completely alien thought in 2007.

It was one of those "don't care" situations. Oh, they're a big bank. They wouldn't choose to take on more insurance than they can handle (or whatever). I don't care which bank is the CDS insurance, I just want some insurance from somebody. Besides, mortgages have been reliable for decades, getting CDSes to cover my ass on an already safe mortgage is the height of paranoia. Etc. etc.

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You also have to remember that various banks work pretty hard to "hide their hands". If you hear that a big bank is selling CDOs, the all the smaller banks will similarly sell CDOs (trying to get a "piece of the action").

If you're a big bank deciding to make a $500 Billion bet, you really want to make sure that the details of your bet remains a secret. Otherwise, the smaller banks (who are more agile than you) will make those deals before you finish your deal.

[arethuza]

Thanks for the patient explanations! :-)