Definition: Credit default swaps (CDS) are contracts that insure against default of municipal bonds, corporate debt and mortgage-backed securities. They are sold by banks, insurance companies and hedge funds who collect a premium for providing the insurance. 

Here's how it works. A company issues a bond, which is the same thing as asking for a loan from whoever buys the bond. Several companies buy the bond (lend the money), but want to make sure they don't get burned in the off-chance the company goes bankrupt.

They purchase a credit default swap from a third party, which guarantees the bond.

Pros 

Like any insurance, swaps allow companies to buy protection against an unlikely, but devastating event. This allows them to fund riskier ventures than they might otherwise, stoking innovation and creativity.

Companies that sell swaps normally protect themselves with diversification. That way, if one company or even industry defaults, they have the fees from other profitable swaps to make up the difference. Normally, swaps provide a steady stream of payments with little downside risk. (Source: Forbes, Credit Default Swaps Are Good for You, Oct. 20, 2008)

Cons

Swaps were unregulated until 2009. This means that, when the bond defaulted, there was no regulator to make sure the seller of the CDS actually had the money to pay the holder. In fact, most financial institutions that sold CDS only held a small percentage of what they needed to pay the insurance. In other words, they were undercapitalized.

When CDS were only sold as insurance, the system worked fine.

That's because most of the debt that was insured did not default. Unfortunately, the CDS gave a false sense of security to bond purchasers. They bought riskier and riskier debt because they thought the CDS protected them from the risk.

Dodd-Frank

In 2009, the Dodd-Frank Wall Street Reform Act mandated that swaps be regulated by the Commodity Futures Trading Commission (CFTC). It specifically required a clearinghouse be set up to trade and fairly price swaps.

However, many banks are shifting their swaps overseas to avoid U.S. regulation. Although the G-20 countries all agreed to regulate them, many countries are at least two years behind the U.S. in finalizing the rules.

The JP Morgan Chase Loss

On May 10 2012, JP Morgan Chase CEO Jamie Dimon announced the bank lost $2 billion betting on the strength of credit default swaps. By 2014, the trade had cost $6 billion. 

The bank's London desk executed a series of complicated trades that would profit if corporate bond indexes rose. One, the Markit CDX NA IG Series 9 maturing in 2017, was a portfolio of credit default swaps. That index tracked the credit quality of 121 high quality bond issuers, such as Kraft Foods and Wal-Mart. When the trade started losing money, many other traders started taking the opposite position, hoping to profit from JPMorgan's loss. (Source: Reuters, JP Morgan Future Losses at the Mercy of an Obscure Index, May 17, 2012; New York Times, JPMorgan's Trading Loss Is Said to Rise at Least 50%, May 17, 2012)

The Greece Debt Crisis

Swaps' false sense of security contributed to the Greece debt crisis. Investors bought Greek sovereign debt, even though the country debt-to-GDP ratio was higher than the European Union's 3% limit. That's because the investors also bought CDS to protect them from the (at that time) unlikely potential of default.

In 2012, these investors found out just how little the swaps protected them. Greece required the bondholders to take a 75% loss on their holdings. Since it was mandated by Greek law, the CDS were not triggered. This could have destroyed the CDS market, because it set a precedent that borrowers (like Greece) could intentionally circumvent the CDS payout. However, the International Swaps and Derivatives Association ruled that the CDS must be paid, regardless. (New York Times, Greek Credit Default Swaps Are Activated, March 9, 2012; Credit Default Swaps)

The 2008 Financial Crisis

By mid-2007, there was more than $45 trillion invested in swaps -- more than the money invested in U.S. stock market ($22 trillion), mortgages ($7.1 trillion) and U.S. Treasuries ($4.4 trillion) combined. In fact, it was almost as much as the economic output of the entire world in 2007, which was $65 trillion.

Furthermore, they were used to insure complicated financial products like mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). Swaps were traded in unregulated markets between those who had no relationships to the underlying assets. They didn't understand the risk inherent in these derivatives.

As the value of underlying assets fell, and the insurance had to be paid, the value of the swaps fell. This caused the demise of AIG, which had an $11 billion CDS write-down. Other companies that were hard hit were Swiss Reinsurance Co., MBIA and Ambac Financial Group Inc. The breakdown in the CDS market meant less ability to get insurance for loans. As a result, banks became less likely to make loans. In addition, they realized they needed to hold more capital, and become more risk-averse in their lending. This has cut off a source of funds for small businesses and home loans. These were both large factors that kept unemployment at record levels. In this way, CDS contributed to the 2008 financial crisis. (Source: Time, Credit Default Swaps: The Next Crisis?, March 17, 2008) Article updated April 15, 2015.