What are Credit Default Swaps

In the mortgage business, a Credit Default Swap [CDS] is a sale of the risk a borrower will not pay a loan.  The swap is insurance.  The lender sells insurance against the risk of the borrower defaulting on the debt.  Particularly with mortgages, the lender sells the loan.  In order to make the loan more attractive to a potential buyer, the lender offers to swap the risk.  The buyer insures the purchase from the risk of default.

In practice, sellers of credit default swaps sold low, too low in relation to the risk associated with sub-prime mortgages that experienced mass defaults.  Imagine a car insurance company paying out more in accident damages than the company collects in insurance premiums.  When the mortgage loan stops producing, the CDS seller has to make good on the contract and reimburse the mortgage holder for the loss.
To complicate the problem, speculators entered the market, buying and selling Credit Default Swaps without owning the mortgage or being in the insurance industry.  Needless to say, the market underestimated the degree of risk and did not collect enough for this form of insurance.

Enter investment banks.  Banks purchased CDS contracts, as assets, betting on their value.  As mentioned, one did not have to own a mortgage or be in the insurance business to play the risk game so it was difficult to impossible to determine if a bank was exposed to CDS losses.  Uncertainty weighed in, such that banks refused to loan to each other, not knowing whether the other bank were weighted down with costly CDS contracts and unable to pay back the loan.

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