Well, it's all about selling outstrike options. Naturally, the longer the world remains 'nice' and stable, the more people are willing to sell all sorts of tail risk... As to why nobody wanted to buy them, I think it's, as the AI guy pointed out, all about the various restrictions on balance sheets. There's no appetite to exploit mispricings, because, no matter how you slice it, it requires an outlay of capital (probably can't repo these things no matter how much you're willing to pay).
Yeah, it's a crazy environment and it is exactly how you understand it. Although, we are in a high default environment, the majority of the IG CDS market is money good. In a nutshell, the posting of cash is a day to day ordeal. The problem is that the wide spreads have persisted for many months and although they will retreat as the markets thaw, eventually, the money will come back in the door to AIG. As you can see, the issue is that the loss is not really a loss but an accounting issue. The investments are likely to be money good. However, the leverage was the killer. The name of the game for AIG was to put up as little capital as possible against as much notional as possible. The miscalc was that some quant assumed that at worst, $500m of capital would need to be posted to cover the worst movement in MTM of the entire CDS/CDO book. The prob was that the quant likely backed into this number based on historical data. Current spreads are far in excess of any historical data point. Since the $500m number ballooned into several billion, AIG had to find the cash somewhere and since were not Berkshire or MSFT with plenty of cash on hands, and since banks stopped lending, they were stuck with borrowing from the government. In time, the posted cash will funnel back in to AIG when CDS spreads tighten to pre crisis levels. You can monitor it by looking at a daily historical chart of the CDX North America Investment Grade index posted by Mark-It partners. I happen to know details about this debacle since being a part of a non-posting CDO shop. Talk about dodging bullets...