CDSs were designed to allow investors to hedge credit risk — the risk that a bond issuer defaults. A pension fund holding corporate bonds could buy CDS protection to guard against losses. But CDSs are also used for speculation: you can buy protection on a company's debt even if you don't own any — essentially betting that it will default.
How a CDS works
The CDS spread — measured in basis points per year — reflects the market's view of default probability. A CDS spread of 200bps (2%) on a company's 5-year debt means protection costs 2% per year — roughly equivalent to a 2% annual default probability in simplified terms.
CDSs as a market signal
CDS spreads are one of the most sensitive real-time indicators of credit stress. When a company's CDS spread widens dramatically, the market is pricing in increasing default risk — often before credit rating agencies downgrade the company (agencies are notoriously slow). During the 2008 crisis, Lehman Brothers' CDS spread spiked to thousands of basis points days before its bankruptcy, while its credit rating was still investment grade.
How CDSs amplified the 2008 crisis
AIG, the insurance giant, had sold protection via CDSs on $500 billion of mortgage-related securities. When those securities collapsed in value, AIG was required to make good on its promises — but couldn't. The US government had to bail out AIG with $180 billion because the failure would have cascaded through every major bank it had insured. The problem was that CDSs were traded over-the-counter, with no centralised clearing — so no one knew the full extent of exposures until it was too late.
What this means for you
CDS markets are a useful signal of credit stress — watching sovereign CDS spreads during the Eurozone crisis, or corporate CDS spreads during a recession, gives you real-time market-based credit assessments. Post-2008 reforms (central clearing, margin requirements) reduced the systemic risk that made 2008 so catastrophic, but CDSs remain controversial because they allow massive leverage and "naked" bets on default that critics argue serve no economic purpose.