Unlike insurance, however, CDS are unregulated. This means that, when the bond defaults, there is no regulator to make sure the seller of the CDS actually has the money to pay the holder.
When it was only sold as insurance, it worked fine. However, soon CDS were used to insure complicated financial products like mortgage-backed securities (MBS) and collateralized debt obligations (CDO's). Swaps were traded in unregulated markets between those who had no relationships to the underlying assets.
By mid-2007, there was more than $45 trillion invested in CDS - more than the money invested in U.S. stock market ($22 trillion and falling), mortgages ($7.1 trillion) and U.S. Treasuries ($4.4 trillion) combined. In fact, it is almost as much as the output of the entire world in 2007, which was $65 trillion.
As the value of underlying assets fell, and the insurance had to be paid, the value of CDS fell. This is partly what led to the demise of AIG, which had an $11 billion CDS write-down. Other companies that have been hard hit were Swiss Reinsurance Co., MBIA and Ambac Financial Group Inc. The breakdown in the CDS market means less ability to get insurance for loans, which also means banks are less likely to make loans. (Source: Time, Credit Default Swaps: The Next Crisis?, March 17, 2008)
