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Credit default swaps are neat. They are intended to act as insurance against a default, or failure to repay, of a bond or similar loan. If you had bought bonds of, say, Lehman Bros., you could also have gotten a credit default swap for roughly a penny on the dollar to insure against the bond failure, back when Lehman was whole. The CDS seller would pay you the par value of the bond should the bond default.
Here's the neat part. You can just buy the credit default swap without the bonds. It's like taking out a life insurance policy on a complete stranger! If something unfortunate should happen to that business, putting its bonds in default, you can collect on the CDS.
Now, suppose you got together with some friends and bought CDS contracts on some company, like, oh say, Bear Stearns or Lehman Brothers Holdings. Then, suppose something unfortunate happened, like a massive selloff in the stock of those companies. Now, I bet the folks with bonds issued by those companies might pay considerably more than you did for those contracts.
Think of it this way. You, Vinnie, and a few other associates buy a term life policy with reassignable benefits on the old guy that runs the corner newsstand. A few days later, something unfortunate happens when a delivery truck smashes through the newsstand and puts the old guy in the hospital. Being as he is not expected to live, you approach the old guy's wife and offer to reassign the insurance policy to her in exchange for a modest fee, say 80% of face value. Hey, accidents happen.
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