A decent primer on credit default swaps is featured in the Washington Post. Here is the punch-line:
Credit-default swap is a complicated name for a simple concept.
It is a legal contract in which an investor who buys, say, $10 million worth of bonds could pay from tens of thousands of dollars to more than a million dollars for the insurance, depending on how credit analysts view the safety of the mortgages underlying the security. The insurance contracts enabled banks and other investors to buy securities and hold them as if they were top-grade assets, because even if the security defaulted, the credit-default swap would kick in and make the investor or bank whole.
One big problem: Anybody could write a credit-default swap.
Many in the market now worry that people who wrote the contracts may not have enough cash to honor them, which could leave institutions without safety nets they were counting on to limit their losses.
For more, see Arnold Kling’s post on why CDSs can actually be the cause of systemic risk.