How Credit Default Swaps Became a Timebomb

A Credit Default Swap is a credit derivative or agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer." The second party gives credit protection and is called the "seller". The third party, the one that might go bankrupt or default, is known as the "reference entity."

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.

Such exotic financial products are extremely profitable in times of easy credit, but when markets reverse, as has been the case since August 2007, they amplify risk considerably.

Read about the role Of Credit Default Swaps (CDS's) in the Financial Crisis in a great 3 part article
Link to Part 1

Link to Part 2
Link to Part 3