[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! :-)