CDSs are derivatives; they are assets that are synthetically created and how's value is derived from underlying assets - the debt obligations their holders are attempting to protect against default. Unlike your home, which you do not expect to actually burn down and buy insurance against such a rare eventuality just in-case, CDSs are purchased on the worst debt securities - those rated below investment grade. Of course, these too are the very securities are most likely to default when times are bad and, if you hadn't yet noticed, times they are bad ...and getting worse.
It gets worse. The firms selling these insurance policies are not only unmonitored, but are not officially considered banks - including the likes of JPMorgan, Goldman Sachs and many hedge funds. With losses expected to be as high as $150 billion dollars on the first round of defaults, will these firms be able to survive? Moreover, as we saw with Bear Stearns, can the economy afford the collapse of even one such firm or would it spell disaster for the capital markets as a whole? Unlike Bear Stearns, however, the Fed is unlikely to bail-out a hedge fund.
It gets more complicated. To get a handle on the situation, the first step would need to be to properly value the risk that is actually assumed by these various counterparties, but even this first step is not easily accomplished. Firms resell these securities as they would others - if you're having a moment of CDO-inspired Deja Vu, you ain't alone.
Most fundamentally, the CDSs were created with a very useful purpose in mind: to distribute the risk of a default across many firms that could bear that risk. However, with so few firms actually acting as the counterparty in many of these transactions, the very opposite has happened - with much of the risk concentrated. Go figure!
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