It looks like AIG was the player foolish enough to make the CDS bet without protecting themselves.
http://www.reuters.com/article/us-how-aig-fell-apart-idUSMAR85972720080918
‘Over the past few years, CDSs helped transform bond trading into a highly leveraged, high-velocity business. Banks and hedge funds found that it was much easier and quicker to just buy and sell CDS contracts rather than buy and sell actual bonds. As of the end of 2007, they had grown to roughly $60 trillion in global business.
‘So, what went wrong? Many CDSs were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis, details of which are covered here 1. As those mortgage-backed securities and collateralized debt obligations became nearly worthless, suddenly that seemingly low-risk event-an actual bond default-was happening daily. The banks and hedge funds selling CDSs were no longer taking in free cash; they were having to pay out big money.
‘Most banks, though, were not all that bad off, because they were simultaneously on both sides of the CDS trade. Most banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection to someone else at the same time. When a bond defaulted, the banks might have to pay some money out, but they’d also be getting money back in. They netted out.
‘Everyone, that is, except for AIG. AIG was on one side of these trades only: They sold CDS. They never bought. Once bonds started defaulting, they had to pay out and nobody was paying them. AIG seems to have thought CDS were just an extension of the insurance business. But they’re not. When you insure homes or cars or lives, you can expect steady, actuarially predictable trends. If you sell enough and price things right, you know that you’ll always have more premiums coming in than payments going out. That’s because there is low correlation between insurance triggering events. My death doesn’t, generally, hasten your death. My house burning down doesn’t increase the likelihood of your house burning down.
‘Not so with bonds. Once some bonds start defaulting, other bonds are more likely to default. The risk increases exponentially.
‘Credit default swaps written by AIG cover more than $440 billion in bonds 2. We learned this week that AIG has nowhere near enough money to cover all of those. Their customers-those banks and hedge funds buying CDSs-started getting nervous. So did government regulators. They started to wonder if AIG has enough money to pay out all the CDS claims it will likely owe....
Yes, AIG was world class stupid in their behavior leading up to the crisis.
They thought their CDS was free money.