This item from somebody who knows a bit about the CDS market:

It is quite perverse that if you buy $1 of protection you invariably don't end up with $1 of payout.

Due to the numbers of buyers and sellers in the CDS market being vast (one bank could be on both sides of the market hundreds of times) the settlement process if someone goes belly up tends to be an auction.

Hence why WaMu (Washington Mutual) CDSs are paying you roughly 50c in the dollar and you basically pay or receive your net obligation x the discount factor.

The whole idea of the CDS market is actually a very sensible and logical one. If I as `Bank A' have lent BHP $5 billion at Libor + 250bps for five year then that is a very valuable asset on my book, so I am willing to trade some of that large potential profit away (assuming my cost of funding is say Libor +20bps). Likewise BHP may be owed five years' worth of gold proceeds in an annuity swap from `Bank B' (based on their mineral production) so BHP may then go and buy protection on Bank B. It can become quite circular.

Where the whole process fails (and this is the only evil part of it all) is that liquidity in the CDS is inverse to the volatility of the market. Hence with the recent meltdown many of the prices were indicative.

Some clever cookies at some hedge funds thought that if they got themselves into the market bidding up sharply the CDS levels on, say, Bear Stearns, Lehman and finally WaMu, then that was one of the most effective ways to create panic and gain from then shorting the stock.

In a nutshell:

1) The market sees the CDS level go through the roof even though the CDS market has become illiquid and very little would indeed be trading.

2) The rating agencies see this and say, "Gee, if Lehman five-year CDS is at 1000 (10% over Government) then this is not a long-term funding level that their business can operate at so we will downgrade them from A+ to B-".

3) The market responds by dumping Lehman stock

4) 1 through 3 continues either until someone takes over the company or it goes bankrupt

Process 1) is where there needs to be a regulated clearing house to stop manipulation.

So I guess my view is that CDSs worked for a long time under "normal" market conditions and helped in the strengthening and lowering of credit exposure ...a very important function. Only recently did the system get abused. And as shown in the article, a notional market of $50 trillion doesn't mean someone could lose $50 trillion. The net flows are perhaps less than 1% of that across the whole market and across many names ...quite manageable.

The real fools in this whole process are of course the rating agencies. The idiocy of these guys is staggering. Let me go into that another time but simply put, they are hired guns, "selling" their ratings and understanding very poorly the underlying risks in the stuff they stamped.

Furthermore they were stupid enough to have proliferated this whole market meltdown by downgrading exactly at the time when they would have been best commenting to the effect that it was not possible to assess due to illiquidity and volatility.

Why downgrade anyone when the entire corporate bond market had shut down and not traded for months, citing the inability to issue at these wider spreads (it affected everyone). Their part in 2) above was like being lemmings over the cliff and as much as the results were disastrous, I do kind of acknowledge the balls and cunning of some hedge funds in playing these guys like a guitar.

West: certainly couldn't have said it better ourselves.