They were the key reason for the demise of AIG and a large part of the reason for our current mortgage mess.
If you buy a bond from General Motors or mortgage bonds, you are lending them money for a set interest rate for a specified length of time. You face two risks.
1. They go bankrupt and don't pay you back.
2. That interest rates rise and the bond falls in value (think of bond prices and interest rates as being on opposite sides of a see-saw).
Investors in bonds often choose to take out a "type" of insurance aganst these risks. For a given premium, the seller of the CDS will (supposedly) pay off on the bond if it goes belly up. If it was from a real insurance company, they would be regulated and would have to hold enough money in reserve to pay you off.
For example, life insurance companies must have enough cash on had to pay off on your policy in case you die. CDS are an unregulated market so someone can sell you CDS without having the reserves to pay off if the bond goes bust.
In the case of life insurance, there are strict limits on who can take out an insurance policy on you. They must have whats called an "insurable interest". You need to have an economic loss if the insured dies to be eligable to insure their life. You can't wander the halls of the hospital looking for people who are unlikely to make it and take out life insurance policies on them.
This is not true for the CDS market. You are perfectly free to take out a "life" insurance policy on GM, or any other firm that issues a bond, including mortgage backed securities and you do not have to be holding the bond or have the reserves to pay off if they fail? And we wounder how our economy got into trouble?
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