[Credit Default Swaps as Defined on Investopedia.com
How They Work
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event."
The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs.
It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the "reference obligation." A contract can reference a single credit, or multiple credits. (To learn more about bonds, see our tutorial Advanced Bond Concepts.)
Insert Mortgage Backed Securities in place of bond to relate this definition to the housing collapse.
As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of the transaction, when the reference entity (the issuer) has a negative credit event. When such an event occurs, the party that sold the credit protection and who has assumed the credit risk may deliver either the current cash value of the referenced bonds or the actual bonds to the protection buyer, depending on the terms agreed upon at the onset of the contract. If there is no credit event, the seller of protection receives the periodic fee from the buyer, and profits if the reference entity's debt remains good through the life of the contract and no payoff takes place. However, the contract seller is taking the risk of big losses if a credit event occurs. ]
So you can see that these could be seen as smart business if you are buying CDS to protect your interest. What changed in 2005 was that CDS started to be sold to uninterested parties. The seller was allowed to offer protection against a "credit event" even if they were not in a position to suffer a loss.
The protection sellers began collecting premiums from uninterested parties that would eventually be responsible for the collapse of their companies. The most recognized company was AIG. They were the seller of protection for MBS.
Bear Trap, The Fall of Bear Stearns and the Panic of 2008
Several billion dollars worth of CDS was sold to Goldman Sachs by AIG. When the MBS begin to fail AIG did not have the reserves to pay the claims. The biggest beneficiary of the AIG bailout by the government was Goldman Sachs. The money put up to by the government was primarily to pay the buyers of the Credit Default Swaps on the Mortgage Backed securities. There were winners that made billions even if they stood to not loose a penny if the entire MBS market defaulted.
Credit Default Swaps also made the sub prime mortgage market grow because as long as investors had the ability to buy protection on risky MBS, they was a demand for this sub prime product.
