Is this the question? The banks bought protection on the CDS on CDO. AIG was a taker of risk. The banks, for the most part and especially in cases like this, tries to hedge those risks by selling protection down the line. But that's all very complicated. CDS on CDO is a very very small part of the market.
Hi sjfan, Good to see another credit guy here. But I have to disagree with you on the above point that when you are long a CDS contract you sold protection. When I buy CDS or go long CDS I buy protection and am short risk. But if I'm long a credit then I'm long risk and have sold CDS. Agreed?
Wait - this is right. You've sold [protection on the] CDS.... I think there's where the terminology is getting flipped. We are used to saying buy as in buy protection, not buy as in long. If buy == going long, then you've sold protection. I think the original poster thought long means he makes money when spreads widen, which isn't true - that's buy protection or going short. Agreed?
F*ucked. I'm pretty sure most of buy side firms are still trying to sort out their positions and where they stand with respect to Leh as their counterparty.
Could you maybe provide an example of a bank selling protection down the line? Would it just be calling up AIG and asking for some insurance? Really, I don't think we're going to come across this sort of info elsewhere... Thanks again for your insight. The media (who unsurprisingly seem to have little understanding of the CDS market) have made it sound like CDSs on CDOs is the major problem. Also, cheers to simpleton for helping elucidate the terminology
No. Once you get to the credit derivatives world, that's where insurers and re-insurers go to layoff their risk, not take them on (except to invest their own asset. See later paragraph about how banks and other large financial entities have many desk that are independent of each other for all intents and purposes). The natural buyer of credit default protection are the banks themselves. They usually have a very large book of various loans and debts issued by corporates and syndicated by them. As technically a market maker, they don't want the risk of holding on these books (which they still do, and bleed red for it), so they naturally want to buy protection on these debts. So they buy default protection from their own or other banks' credit derivatives desks. The credit derivaties desk thus have a natural supply of short players. So, basically, AIG (or whoever else) comes and sell protection, the credit desk is thus short protection. The banks' warehouse is naturally long default risk (they warehouse the bonds) and thus want to short default risk to hedge themselves, so they go to the credit desk to buy protection. Since the desk is naturally short protection, that transfers over just fine. It's useful to think that the desks within a single bank are fairly autonomous and can at times deal with other banks instead of the trading desk of their own if it means liquidity and price improvement.
Maybe this example helps: Here's a typical example from both the buyside and the sellside: I do my credit analysis and I think its a crap credit and that 5 year CDS trading at 200bps is way too tight. So I look at my Bloomberg and see that the dealers are making a market 195/205. I buy CDS/protection at 205. I've just gone 'Short' the credit. The IB that I just traded with is now long the credit or short CDS/protection. He has access to the interdealer broker market where he can choose to layoff his risk and make a few bps riskless or maybe the trade offsets his current position in some form. Hope this helps.