Taking bets you can't pay out on

Just as with collateralized debt obligations (CDO), credit default swaps (CDS) are difficult to really understand, even after reading several explanations. Both are however critical to understanding much of the current problems in the finance sector. I understood that they were a type of insurance financial institutions could buy to cover their investments, but I didn't get how they could bring down large institutions.

A post by Satyajit Das on his blog went straight over my head so I went looking for something like this to explain the concept better. This one helped a bit by showing the interconnectedness of the large institutions effectively insuring each other for related risks, but still didn't quite fully explain it for me.

This facinating article from Rolling Stone linked to from Peter Martin's blog has given me the best explanation so far. CDSs were insurance policies sold to cover investment risks by people who had used the wrong risk models. Unlike insuring cars against theft, where large numbers of cars are extremely unlikely to be stolen simultaneously, but the event of a market crash (mistakenly calculated to be exceptionally rare like mass theft) can bring down the value of all investments in concert. Some made lots of money selling them before the music stopped. CDSs also formed a kind of short as players were able to buy insurance on assets they didn't own, akin to taking out an insurance policy on your neighbour's house.