I’m not in charge of any such book, but c’mon there have to be risk limits on this kind of thing. Really, if there aren’t, the entire risk department at the bank has to be fired.

If protection sellers were to default en masse, so too could some protection buyers who erroneously assume that they are protected. Given that the CDS market is largely unregulated there is no guarantee of sufficient liquidity behind each contract.”

In this sense, Bill Gross’ estimate is a ‘gross’ estimate. Is there any way of scoping the potential net damage, taking into account the ‘0 sum game’ characteristic?

In theory that is true, but in practice, the volume of CDS is so far in excess of the underlying that most of the positions are unhedged or are being “hedged” with other CDS.

In the Adelphi bankruptcy, the amount of CDS written was ten times the amount of cash bonds. And remember, you can short stock only to the extent you can borrow it. There is not way that the market value of Adelphi was ever 10x the amount of its bonds, and even if that had even been true, no way that 100% of it could be used to short.

In fact, at the time of the Adelphi bankruptcy, the rules in the contracts were that you had to submit collateral (the bonds) in order to collect on your CDS. The rules were waived to prevent the collapse of the market. I assume subsequent contracts call only for cash settlement.

Since CDS are used for many reasons, including creating synthetic debt exposures (in fact many investors reportedly prefer to use CDS to buying bonds), the amount greatly exceeds the amount of underlying debt (I remember reading the 10X number is generally operative, but I can’t recall where I saw that).

And per Gillaume’s comment (which I believe is correct) if you have more CDS in lower credit quality stock, there will be even less stock (in the sense market value is lower) available for shorting.

Suppose you write a CDS that company W will go bankrupt, i.e. you pay 100 if there is a default event.

And suppose there is now a bond of Company X which trades 90. You calculate that, if X defaults, the bond will fall to 40. Then a very simplistic calculation shows that you can hedge the default risk on the CDS by shorting two bonds. Or the stock is worth 10. If the company defaults, the stock will fall to 0, so you can sell short 10 of the stock to hedge the risk of default.

So the point is: CDSs are not a closed system. They can be hedged, with bonds or with stocks. Simply treating them as naked positions will result in incorrect calcuations as to how much people will lose, because they have (or they should have) offsetting positions which will earn them money should they have to pay out on their CDSs.

The risk in this kind of thing is the models, and unexpected events which cause jumps (eg Bank of America buying Countrywide). Every meltdown, being different than the last, shows yet another problem with the models, and losses (and sometimes gains) result.