What is a credit default swap (CDS) ?

A credit default swap (CDS) is a financial instrument originally invented to insure the owner of a bond against default. They exploded in popularity and were the cause of one of the greatest bubbles. The 50 employees at AIG's Financial Product division creating and trading CDS brought the insurance giant (120,000 employees) to its knees in 2008. Frank Martin at MCM Advisors in his 2008 annual report explains this exotic financial instrument through the 'HDS Fable':

Flash back to 2006 and engage your imagination regarding a particular house. Suppose, if you will, that 50 neighbors have become infected by the speculative virus. The ingenious neighbors concoct what becomes an active market in HDS (home destruction swaps), buying and selling contracts, essentially taking both sides of the bet that the house will go up in flames. Those who think an accident is likely pay insurance-like annual premiums to those willing to hold the opposite view. For a contract to come into existence there must be both a buyer of risk insurance and a seller who is willing to underwrite the risk. Although there is only one house at risk, the number of contracts outstanding is limited only by the number of parties willing to enter into a swap agreement related to that particular house. Unlike a conventional homeowner’s insurance policy with a limit of one per house, these synthetic policies have no such limits. When the speculative appetite is well nigh insatiable, they multiply like rabbits (but it’s hare today, gone tomorrow). Always thinking of new ways to make their money work harder, the swap sellers, those willing to underwrite the risk that the house will be destroyed, put their proceeds to work in the rising stock market. Likewise disposed, buyers pay their premiums with money borrowed at the local bank. Everyone knows that financial leverage amplifies returns (although they conveniently forget that it has the same effect on risk). Suddenly circumstances change. The house is sold and immediately a rumor spreads that the new owner is building a potentially explosive meth lab in the basement. As the perception of risk of fire rises sharply, the protection sellers are taking huge paper losses, while the buyers are racking up big gains. The buyers naturally want to cash in their gains and reduce their debt. But the sellers can’t close out their positions at the new price. And since this is a small and transparent market, other potential buyers have no interest, because the sellers are too weak a “counterparty.” And bankers are making collateral calls on their loans. Thus the buyers of the HDS contracts discover to their dismay the meaning of “counterparty risk.” Now, suppose there’s a modest stock market downturn, just as the HDS buyers’ banks are haircutting the nominal paper gains on their HDS. The bankers will start calling for more collateral for their margin loans, which many buyers can’t meet. The sellers, of course, are in even worse shape; they’re taking paper losses, and their stockbrokers have adopted much more aggressive tones. Both buyers and sellers may end up bankrupt. And so the fable ends with the meth lab madman in jail, the innocuous little house, the object of so much reckless risk taking, still standing. Though the structure didn’t collapse as expected, it was in a very real sense a house of cards—as the 50 speculators discovered to their chagrin. Left in the wake of the massive speculative episode where risk was created out of thin air are 50 financially and otherwise devastated families. The inebriate who insisted on smoking in bed, source of the comparatively insignificant original “risk” upon which the mania took root, never had a hint of what was going on in the neighborhood around him.