Some thoughts on synthetic CDOs and risk pricing of those selling credit default swaps.
Many people have written about the ‘correlation risk’, of CDS sellers, that is, the risk that defaults on basis securities are correlated. Real insurance is based on the expectation that the insured are not going to experience a catastrophic event simultaneously. But the CDS market had two kinds of insured parties: ‘Hedgers’, who own the basis security, and ‘Gamblers’, who do not.
It would be downright foolish for someone selling CDSs to price them the same for hedgers and gamblers. Even the purchase of CDSs by hedgers should decrease confidence in the underlying security, as the risker the security the more likely the need to hedge. However, the buyers have no reason to hope for default, and one can even imagine a highly risk averse investor buying CDSs on low risk securities; the premiums ought to be very small, after all.
A gambler wanting to buy a CDS on a security, however, ought to set off red flags. Their only interest is in seeing a default. That means that they believe the seller is underpricing the CDS. And not by a little, otherwise they would be in a lower risk game than buying CDSs.
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