Credit default swaps are widely used in subprime mortgages. Its purpose is to ensure that those companies with low credit ratings will not default. However, due to the mass production and excessive concentration of this product, some companies with good credit have been dragged down, and thus a chain reaction has occurred. It broke the insurance chain and caused the expansion and spread of the subprime mortgage crisis.
For example, Company A with a low credit rating applies for a loan from Bank B. On the one hand, Bank B hopes to complete its business, but it is worried about the potential default risk brought by the low credit rating of A.. At this time, another dealer with higher credit rating, C, provided a product, namely credit default swap (CDS), so after providing a loan to A, B paid a certain fee to C to buy the product, and actually concluded a contract. According to the contract, if A breaches the contract, C will buy the loan contract between A and B, and C will pay the loan amount of A to Bank B ... and C has the right to recover from A. In this product, B will avoid the risk brought by A's lower credit at the cost of credit default swap.
In fact, CDS has changed from an initial risk management product to a speculative product, and many buyers of CDS do not actually hold low-credit contracts, which makes the virtual economy divorced from the actual demand.
For non-professionals, it should be noted that credit default swap is a financial derivative product, which can be regarded as a complex futures or option product portfolio, rather than an insurance product. Although it has certain insurance function, it is actually the embodiment of the risk control function of financial derivatives.
Further reading: How to buy insurance, which is good, and teach you how to avoid these "pits" of insurance.