I assume by now everybody in the trade knows about the trick of shorting the stock while buying CDS. Much more effevtive and capital-efficient than just shorting the stock. But that's child's play. Any self-respecting player would short the stock, buy the bond to hedge himself, and buy CDS -- not from anybody, but from the reference entity itself. This way, if the company goes down, you come out ahead with your shorts and CDS while your bond gets 100% recovery (or more); if it doesn't go down, you unwind short and CDS, and make your money on the bond (not nearly as fun as when the company goes down, for sure).
Does it make sense to buy insurance from the guy whose life is insured on it? No, you say? But no to that, sucker। In the wonderful world of bankruptcy court, it does make sense. Because CDS counterparty claim is above senior debt. You get your claim even under Chapter 11, when senior debt holders cannot cash out.
Lehman senior debt is trading at 15 cents on the dollar। Why is that? Presumably, when Lehman exits Chapter 11 in a year, housing markets will have stabilized somewhat, 20% will have defaulted -- ok, 40%, which is NOT going to happen even in the worst form of subprime, but you still get 60% recovery. Lehman may be holding some equity tranches of mortgage CDOs, which is worth precisely 0 unless Paulson buys it with tax-payer money, and some mezzanines, which is worth precisely 0 unless Paulson buys it with tax-payer money. But these CANNOT be the bulk of their asset. So why 15% today?
My guess is that Lehman has sold a lot of CDS on Lehman over the years। As buyers of such CDS claim their payout, recovery for senior debt holders will be diluted.
Just my wild guess। Don't bet your money on it.
Oh, BTW, in case you haven't read the articles I mentioned at the beginning (yes, read them both), companies can jack up their balance sheet and capital adequacy without getting a penny। They borrow $100M from you, give it right back plus interest minus some. But they look very strong as far as regulators and accountants are concerned -- $100M more tier-2 capital.
I'm not saying this is what's happened. Again, just my wild guess and don't bet your money on it.