It's something that Normal bankers could not even come up with !
In its best form, it is an insurance for your bond. For example, you have a bond worth $1000 from company X. There is a small risk of the bond becoming worthless in case Company X goes under. So you go to a private party, and say - let me transfer the risk of value of my bond going under to you for a small fee.
The problem is, people started to get this insurance without even being the owner of this bond !!! So now, it has become a kind of betting !!! Which is where the problem starts.
So now, we have about a 10 people betting that the bond someone holds is going to fail, and they would be paid the full value of the bond in case of failure !!!
Now, in a good market, it's simply people who have sold this insurance that earn money off of this deal. But when even ONE such bond loses value, someone ends up paying 10 parties the entire value of the bond - each!!
Now, come to a market where a whole plethora of such bonds are becoming worthless. The "private insurers" have to pay out 10 times the value for each failed bond.
Now, credit default swaps are:
- Unregulated
- Private Agreements
- Highly Leveraged
