A risky bond plus CDS = a risk free bond,

If you have a risky bond and buy cds, then ignoring counter-party risk, you have a risk free treasury bond. That means that selling credit protection (selling CDS) is just like borrowing money to invest in a risky bond. So, people selling CDS (AIG) were borrowing money to invest in risky bonds. Once the risky bonds turned bad, leverage is going to screw you. Hence AIG.

The giant CDS number being bandied around is overinflated by at least a factor of two and most likely much more. If I buy insurance on $1 worth of bonds, then it is counted as CDS on $1 of bonds by the buyer and CDS on $1 of bonds by the seller for a total of $2 in notional. Double counting. And if the seller hedges by buying insurance or CDS someone else, it is counted yet again. No one really knows the size of the market.

And even so, the value of the insurance is not $1 per $1 of bonds insured, but much, much, much less. For example, if the bond has a face value of $1 and an equivalent risk free bond should sell for $1.05, then the CDS is worth 1.05-1.00=$0.05, not $1. Bu it is measured as insurance on $1, and that is the reported number. So take those giant numbers with a grain of salt.

God knows why we did not have centralized clearing systems for these contracts, so that all counterparties would know those numbers. Someone is going to end up really rich out of all of this-likely people who have been writing CDS in the last few months.

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