Credit Default Swaps are the very dangerous side-bets (unregulated insurance) that Buffett called the "WMD's" of finance. The value of this market is estimated to be $65 Trillion, up from a few hundred billion 8 years ago, a dangerous number. The total credit market debt is less, 51 trillion. See here. Those who sold the derivatives (like sub-prime) would often offer their own "insurance policy" if the buyer feared a default.
Buyer: "I'd buy your derivative if I could protect myself if it defaults."
AIG: "Lucky you, we also insure you from default on our own derivative product with another product, called a swap."
That was only the origin of the swap. Then, third parties could come in and place their bets on whether any company would or would not default. Can you imagine how many people might have bet that a 100 year old company like Lehman would never default? Well, they defaulted and someone has to settle all these contracts on October 10th.
Because the swap was cleverly conceived not to be "insurance", AIG and the sellers didn't need to keep cash reserves to back this new insurance product. Therefore, now there is a $65 trillion unregulated market betting on defaults without cash reserves. The more companies that default, the more the system will be tested. A few serious defaults, especially accelerated defaults, could wipe out the participants in this market causing aggravated losses to both the sellers (investment banks, insurance) and the buyers, pension funds, etc... See here.
OCTOBER 10, 2008 could be the start of the hard testing, triggering third party defaults on these bets. See here. This could mark the start of the swap crash. If you add 30-to-1 leverage and a CDS market, arguably, these bankers could have been betting 1, 2, or 10x's each dollar on swaps. The market at 65 trillion suggests exactly that.
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