Generalizing [and inspired by] daveangel's answer, I would say the hedges became hard to do for various reasons:(1) Extremely high implied vols, so puts are expensive. CDS are expensive (making Paulson rich), etc.(2) Doubts about the solidity of counterparties, daveangel's point; e.g. after AIG, Lehman events "who is next?"(3) "Uninsurable" type risks for certain mortgage securities containing toxic, nontransparent assets. (The academic distinction between "uncertainty" and "risk" comes into play; you can't insure against events that are poorly quantified or completely unquantifiable. A bit of the old joke "it is difficult to insure a house when it is already on fire". In theory it is very expensive, in practice it is essentially unavailable.)...so the [hypothesized] hedging simply could not be continued after a while. [Which shows that in the long run the two things Alan said are the only way practical ways to reduce risk].
Last edited by acastaldo
on September 28th, 2014, 10:00 pm, edited 1 time in total.