A credit default swap (CDS) is a contract which transfers financial risk from one party to another. In a credit default swap, the buyer pays the seller premiums over the lifetime of the contract, in exchange for the seller's assumption of risk. If the credit instrument involved in the credit default swap defaults, is radically devalued, or undergoes another catastrophic financial event, the seller pays the buyer the face value of the credit instrument.
Put in simple terms, let's say that John borrows some money from Suzy. Suzy might decide that she doesn't want to assume the risk of default, so she approaches Julian and negotiates a credit default swap. Suzy pays Julian premiums in exchange for his assumption of the risk of the loan. If John repays the loan successfully, the contract ends. If, however, he decides not to pay it, Julian must pay Suzy the face value of the loan.
The concept of the credit default swap was pioneered by JPMorgan Chase in the mid-1990s, to allow banks, hedge funds, and other financial institutions to transfer the risk for corporate debt, mortgages, municipal bonds, and other credit instruments. By 2007, the market in credit default swaps had grown to twice the size of the American stock market, and because this industry was largely unregulated, some serious problems began to emerge.
One of the biggest problems with the credit default swap is that it is supposed to work like insurance, but it doesn't, because the insurer, the seller, is not required to provide proof of the ability to cover the debt in the event of default. Furthermore, the contract can be transferred, so while the original seller might have been able to cover the credit, people further down the line might not be able to.
To go back to the example above, if Julian turns around and sells the contract to Mary and John defaults on the loan, Mary might not be able to repay Suzy. Mary might even sell the contract to another party, making it difficult for Suzy to track down the holder of the contract in the event of default.
Trading in this credit derivative product began to be recognized as a problem in 2008, when several financial companies including the insurance giant AIG realized that they were unable to cover their credit default swaps. The problem was exacerbated by the American subprime lending crisis, as thousands of homeowners defaulted on their mortgages, putting intense pressure on the banking industry.
