Credit Default Swaps or CDS have played an important role in the current financial crisis. Some blame them for the initial outbreak of summer 2007.
Imagine you lend $10,000 to a friend. You may want to take insurance against default of payment from this friend. For about $300 a year, someone will reimburse you the entire $10k if your friend defaults. This is a CDS, a "credit default swap", think of it as you would car insurance. In the event of a default you "swap" the liability with your counterparty. You get cash (or sometimes equivalent security), he gets the bond. CDS then are taken on bonds. You can buy a CDS on a bond from a company on a bond from a government, on an obscure tranche of a securitized loan. You can buy a CDS on pretty much anything.
The economic function is pretty straight-forward, it moves the burden of default to a willing and able party. If loosing 10k is a devastating effect for you then you may want to swap the default. If it isn't then you may want to sell the CDS and get the premium. On first analysis CDS are a good thing as they move the risk around.
AIG and the concentration of risk
In practice however CDS have ended building up on one balance sheet, that of AIG, the large insurer. Consider for a second that debt usually constitute a large part of the capital of a company. Here a company is selling insurance that puts it on the hook for the debt of many other companies. When you factor in naked CDS (see below) that multiply this amount, the balance sheet that takes it on better be a large balance sheet.
Imagine a local salesman sells insurance against default from your friend's debt, and he sells many of them, say 10. He is on the hook for 100,000 but in practice it is unlikely everyone defaults together. But there is a bout of swine flu and everyone dies. In practice AIG had sold CDS they could not possibly honor when the context changed. AIG being so big makes it a juicy target for government intervention and bailout.
Pushing for default
President Obama just spoke out against hedge-funds resisting Chrysler restructuring. The main reason for this behavior was probably CDS. If you hold a CDS, in the event of bankruptcy, you want to see the company default since it will trigger the swap. In other words, why settle for a payment of 60c on the dollar when you can get 100c on the dollar. This of course creates members of your capital table that are better off seeing you either completely healthy or completely dead, but not at the capital restructuring table. It makes the system less flexible.
A further abuse of the CDS is the naked CDS, whereby the buyer of the CDS does not hold the underlying bond. Imagine your neighborhood insurance guy sells naked insurance, many people can bet against your debtor. They didn't lend 10,000 they just pay the premium (say 300/year) and if there is default then they get 10,000. There are several problems with this a/ the local mafia guy will take naked CDS and proceed to snuff off your neighbor for maximum gain (see point above). b/ Where there was really 10,000 changing hands there is now n times 10,000 (say 50,000) of liability. The bad debt has been multiplied.
In practice naked CDS to covered CDS was 4 to 1. This means we have 4 times more liability than real debt out there, it is obvious, given the size of the numbers, that eventually there would not be enough money to reimburse 4 times the size of an economy that is ... defaulting.
Payment of banks
It has been pointed out that since traders are paid on the flow of deals they had an incentive to just write and write CDS. One problem was that they showed premium income which should have been set aside as a liability and paid themselves bonuses on this flow. Put simply, imagine a security that defaults at 40% in 10 year. You sell security at 43% over 10 years (to reimburse the 40 and pocket 3). But from an income standpoint, we get 4.3 coming in per year, when 4 should be reserves. Of course the full income was the basis for senior management bonuses and dividends.
Liquidity crunch and the spread of default
Many CDS are settled in cash. This means that at a time when liquidity is hard to come by and people default, the issuer of CDS needs to come up with a LOT of liquidity, a lot of cash, further compounding the problem of liquidity. When a company defaults it would normally sit there, but with CDS, someone has to sell assets to cover this hole. This is liquidity drained from healthy parts and so the liquidity problem spreads.
Contribution of Aug 07
CDS were the main contributing factor to the very early Aug 07 liquidity crisis which led to a solvency crisis. Many CDS including naked were taken on the tranches of securitized products. When the subprime markets began to dive CDS began to trigger. Many hedge funds (including the famous Paulson fund) had bet AGAINST the markets. Someone needed to come up with the liquidity needed to repay this. So the implosion of the subprime markets started to spread via CDS liquidity needs to other parts of the economy. Note that the liquidity need was multiplied by the ratio of naked CDS. The liquidity needs may have triggered forced liquidation in certain parts of the shadow financial system. This is how the subprime virus quickly spread and mutated, via naked CDS.