WE ALL WEAR SHORT-SHORTS
Suppose you have credit default protection supplied by Morgan Stanley. That means that you are exposed to Morgan Stanley, as issuer, in addition to the target of the protection (say a GM bond that you've own).
You might want to buy protection on Morgan Stanley, but no one is selling it, except at ridiculous prices. So, you ... short the stock, instead, if you are really worried, and the price to borrow stock hasn't already gone through the roof. (I guess you'd have to be "really" worried, because there may be some collateral involved for your CDS already, to reassure).
Clearly, if there are a lot of people closing-out / selling their protection back to their dealers and selling the bonds they are worried the most about, would you think that swap spreads and high yield spreads would rise to unheard of levels? Uh, yeah.
...if this kind of a credit-swap, worry-induced run-for-liquidity is occurring, it will peter out presto, when every seller is satisfied, and, in the meantime, the dealers could make a *huge* sum in trading profits.
Either that, or your worry may induce you to seek an immediate 'unwind' of the MS's swap, and possibly to sell out of your bond, if you are still worried about having it insured (your recession expectations rising faster than others, etc.). Clearly, if there are a lot of people closing-out / selling their protection back to their dealers and selling the bonds they are worried the most about, would you think that swap spreads and high yield spreads would rise to unheard of levels? Uh, yeah. One step further: if this kind of a credit-swap induced run-for-liquidity is occurring, it will peter out, when everyone is satisfied and dealers are no longer worried about getting slammed. In the meantime, the dealers could make a *huge* sum in trading profits....if this kind of a credit-swap, worry-induced run-for-liquidity is occurring, it will peter out presto, when every seller is satisfied, and, in the meantime, the dealers could make a *huge* sum in trading profits.
EQUITY GOES BI-NARY
Of course, the Paulson put means that Morgan will not fail, but he might let common shareholders get massively diluted (like AIG?).
Suddenly, your investment is either worth a lot, lot more or worth zero, i.e. either it is worth $20, say, or it is worth $0.
Of course, if the government is willing to make injections without penalizing common holders, the the stock looks like a screaming buy, if you find evidence that there are a lot of nervous default protection buyers with a short interest.
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