Question about credit default swaps -- can damage be limited because of "physical settlement"?

[HamdenRice]

<sorry to repost from Economy, but needed more opinions on this:>

One of the criticisms of the credit default swap market is that the people and companies that bought "insurance" on debt (often called the "reference security") didn't have to own the debt. That meant that the widespread selling of cds was like people buying fire insurance on homes they did not own.

It also meant that sellers of cds, like AIG, could get into trouble by selling many times the value of an entire outstanding security. For example, if Bear Stearns issued $100 million of, say, Series A Mortgaged Backed securities, if cds were like insurance and you had to own the property to insure it, the maximum exposure of a cds seller like AIG on that security would be $100 million; but if anyone could buy cds, then it was like gambing and if 50 times as many people bought cds on Bear Series A MBS, then AIG's exposure would be 50 x $100 million = $5 billion

But don't many cds require "physical settlemnt"? In physical settlement, the owner of a cds must present the actual insured bond to get paid. In the example above, no matter how many cds AIG had sold on that series, the only cds holders who could cash them in would be those who had, or could get hold of, an actual physical Bear Stearns MBS certificate (or a depository equivalent). All other holders of cds would be out of luck -- appropriately so.

I vaguely remember this to be true. During the Lehman liquidation, iirc, cds holders tried to cash in their cds on defaulted Lehman bonds, but suddenly there was shortage of defaulted bonds because so many cds holders were trying to buy them. In fact, it caused a weird rally in defaulted Lehman bonds.

So if physical settlement is required, doesn't that basically eliminate the entire problem of cds liability being bigger than the amount of the underlying reference securities?

[Phoebe Loosinhouse]

1. Wouldn't that be something the cds buyers would be aware of up front?

"Physical settlement" SHOULD be required, but I have never heard or read that it is/was. If that were true, why would so many jump on a bandwagon to bet against securities they did not own?

Is this anything like the "naked shorts"? where you don't technically own the stock but you own the option on the stock when you go short? Am I phrasing that right?

You know, Hamden Rice, YOU are the guy I would expect to respond with the answer to someone posting your OP.

[HamdenRice]

3. It is kind of like naked shorts

From what I've read, people bought the cds with the view that if there was a default, they could acquire the defaulted securities later, and it has turned out that there weren't enough to go around.

Now that would be poetic justice right? If companies like AIG get to stiff 90% of the holders of cds because the holders can't come up with the underlying reference security?

I think that not all cds require this, but according to other sources I've read many do. I was just brainstorming about how to limit the damage, and for some reason I hadn't thought about the requirement of physical settlement before.

[Junkdrawer]

2. Look up Kyle Bass... his hedge fund was up 600% after being paid off...

on non-mortgage-secured CDS bets....

He was featured in CNBC's House of Cards special...