Your answer:

“Goldman had some CDS contracts with AIG on other (non-AIG) bonds. As those contracts moved against AIG, Goldman demanded additional collateral (to protect itself against AIG defaulting and being unable to honor the contracts). AIG refused to give Goldman all the collateral they wanted. So Goldman went out and bought CDS protection on AIG.

Put another way: They knew AIG was in trouble because of their existing trading relationship with AIG, and that’s why they bought CDS protection on AIG. That is something that the general public would not have been able to know. How often this type of scenario occurs I do not know.”

That’s what I wanted to know. However, would the price or anything about the CDSs become known. Who’s trading the ones on the market? Or is it that, GS can keep the CDS private, and the info will only get out if they try and sell them?

What you say makes sense, in that there is a chance, as I said, that if the info about these GS buys gets out, it can further harm AIG. However, if there is a CDS for any company, it does seem that the only reason to purchase a CDS is if you feel that there is a chance of default, and someone else who is willing to take your position on. CDSs don’t seem like Canaries to me, they’ve already passed on. CDSs seem like a reaction to Canaries, and validation of their deaths.

Put another way: They knew AIG was in trouble because of their existing trading relationship with AIG, and that’s why they bought CDS protection on AIG. That is something that the general public would not have been able to know. How often this type of scenario occurs I do not know.

I’m assuming that GS had some AIG bonds or product, against which they’re buying protection in case of default. Or, are you saying that GS went out and purchased some existing AIG CDSs, betting one way or another on a default. I’m still trying to see counterparties or anyone can see that a diligent investor can’t.

“CDS prices of financial companies often reveal problems that are evident to trading their counterparties but that are not yet apparent to equity and debt investors of financial companies.”

This sounds like counterparties are purchasing CDSs in case AIG defaults.When this happens, everyone knows there’s a problem, but not before. That makes sense, assuming that wired investors or others in the loop of this company’s investors don’t find out as well.

On the other hand, it certainly can’t help the fortunes of the company they’re buying insurance against. It looks less like hedging than pushing. I’m assuming that’s what you mean by shorting.

Also, you have to remember, there’s a buyer, and a seller. I can see one having the info, but surely the other end of the deal must see something else.

CDSs are frequently used by financial institutions to hedge counterparty risk of trading partners. As a result, CDS prices of financial companies often reveal problems that are evident to trading their counterparties but that are not yet apparent to equity and debt investors of financial companies. E.g., Goldman Sachs bought AIG CDSs in early August when AIG failed to meet collateral calls made by GS against AIG. By looking at AIG CDSs, an astute investor would have gotten an early warning from AIG’s counterparties that they were worried about AIG’s financial condition. CDS prices sometimes act as canaries in coal mines, i.e. early warning signals.

Unfortunately, CDS purchases are also a cheap way to short stocks. CDS prices are strongly negatively correlated to stock and bond prices as well as a company’s credit rating. A rise in CDS prices will drive down a company’s stock price , bond prices and credit rating and may drive the company into bakruptcy. CDS purchases can be used to drive a weak company into bankruptcy.

You make a good point about CDSs being useful. But couldn’t the same information of trouble ahead be reflected in the:
1) Price of the stock
2) Price of the Bond, or even Mortgage
3) Credit Ratings
4) Analysts Ratings
5) Company filings
Is there any reason to believe that buyers and sellers of CDSs have access to any more info than other traders in these other investments? Or that CDSs are more finely tuned to express movements in company prospects? All the CDS does is reflect the same, common, info differently, or am I wrong?