Credit Default Swaps on Troubled Companies/Countries

Problems:

Banks messing around
This thought occurred to me but idk if it would be practical: Banks could sell a ton of CDS on some set of bonds, then buy the bonds on the open market for low prices when it looks like they're going to be defaulted on, and then allow the seller of the bonds to restructure the obligation (reduce the amount they say they owe) to the point where they don't need to force any bondholders to accept a haircut, and so that way the CDS never gets triggered. This is assuming that the banks are your counterparties in the CDS transaction.

2012.05.20 Business Insider - Joe Weisenthal - Japan Is Never Going to Default
http://www.businessinsider.com/japan-is ... ult-2012-5
- He seems to make some easily-weakened arguments, but it's interesting anyway 1) to see how other people are thinking about this stuff, and 2) as a jumping-off point to come up w/ your own idea about how things are going to play out.
- He argues that "trying to bet against a country based on its debt-to-GDP is a losing idea" and cites as evidence that US T yields have gone down as the US debt-to-GDP as soared, and that "there's actually a slight negative correlation between debt-to-GDP and yield on the national 10-year bond". The problem w/ citing that evidence is that that could be like a guy in January of 1929 saying "nothing bad is going to happen; just look at the market! Up and up and up!".
- In the quote below Weisenthal argues that the reason Japan won't default is that there's so much yen-denominated capital out there that needs to sit in yen-denominated assets that it will of course end up in Japanese gov. debt:

So the whole foreign/domestic borrowing thing is a canard, although it does warrant the question of why it doesn't matter. After all, it does seem logically like it should be problematic that Japan would have to borrow more and more from abroad.

Here's how to think about it...

Foreign ownership of debt is not a function of the country going cap in hand all around the world, looking for investors to buy their bonds. It's a function of trade. When a country runs a trade deficit, it basically means it's spending more on goods from the rest of the world, than the rest of the world is spending on goods from said country.

So it stands to reason that if Japan is buying a lot from the rest of the world, then there are a lot of yen floating around the world: More yen wind up in places like China, the Mideast, the US, Europe, etc.

What happens to those yen? Well, some will get spent on other things, but in the end, they'll all wind up in bank accounts somewhere, and somehow they'll find their way into a Japanese Government Bond, so that the holder of said yen might get some yield. Now theoretically if someone had a bunch of yen, they might prefer to buy German bonds or US bonds, and that's fine, but then there's another private holder of yen who has to make a decision about where they're going to place their currency. Eventually, that currency will find its way home, and the cycle is complete.

The first time I read this I couldn't make sense of it, but the second time a read it (a few days later) I think I understand it clearly and understand what Bass's response could be. His response: 1) if there's a crisis of confidence in Japanese bonds (ie people dont think they're going to get paid back), then that distrust will also spread to Japanese banks that are largely holding Japanese bonds, so you'll see runs on those Japanese banks. At some point people will think it's preferable to keep their yen in cash to having it in a Japanese bank or government bond and risk having it all disappear. Or people will start to distrust the yen altogether and you'll see a currency crisis. So there are a couple different ways you could see this pressure relieve itself, but shorting gov bonds doesn't seem like such a bad way given the low price for the bet. Reading Reinhart's "This Time Is Different" has really made me better at understanding what happens when people start to distrust a country's debt.