What this [writing a CDS on oneself situation] means is that it’s not possible to value a CDS (and therefore any kind of debt for the issuer) simply by looking at the risk of default for the insured firm, and then considering the risk of default for the issuer. You need to know the correlation between the two, and this requires detailed knowledge of the entire asset position of both parties, including their correlations with other parties.
Roughly $400 billion will be paid out on Lehman CDS, but, once all positive and negative positions are "netted" out, about 2% of that money will actually change hands, Pickel estimated
The solution has to be for big financial companies to reveal their positions to the regulators as formal models of the contracts they have written. At the moment they don't even have to reveal all their contracts, but merely knowing the legal terms of a contract is only the first step. Those terms have to be converted into a mathematical model. That model probably already exists, but only as an internal artefact of the parties to the contract. What ought to be happening is that the contract is specified in a well-defined mathematical language that can be converted into a model automatically.
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