Bank X makes a loan to Company Z. Federal law requires Bank X to keep a certain percentage of cash on hand in case Company Z is unable to repay their loan. This cash cannot be loaned out or invested by Bank X. This is a limitation to Bank X because it is much more advantageous for them to loan or invest their cash than to have it in a low (or no) interest bearing account. Here is where the Credit Default Swap comes in to play. In order to free up this cash Bank X sells the risk on the loan made to Company Z to another company, Company Q. Bank X agrees to pay Company Q a certain dollar amount per month in exchange for Company Q agreeing to cover the loan made to Company Z in the event that Company Z defaults. Now Bank X can loan/invest the cash that was previously tied up as the reserve amount for the loan to Company Z. Company Q now gets a new monthly income stream for “insuring” the loan made to Company Z. It’s a win for both entities up until the unfortunate event that Company Z defaults on the loan, at which point Company Q is now on the hook for the loan amount. The contract between Bank X and Company Q is called a Credit Default Swap and becomes a separate investment vehicle that can then be sold by Company Q.
Of course, this is an oversimplified example and credit default swaps are created against a large pool of loans as opposed to a single loan, further complicating the risk evaluation, which was and is part of the problem. Evidently CDSs have been around awhile and didn’t become especially problematic until they became so prevalent with mortgage backed securities (a large pool of mortgages instead of corporate loans). AIG was neck deep in mortgage based credit default swaps (AIG would be equivalent to “Company Q” in my example above).
Allegedly the financial world went ape-shit with CDSs over the last few years and all was well until people started missing their mortgage payments en masse. So here we are.