I'd like to bring everyone's attention to what I think is one of the best articles yet on Credit Default Swaps and the threat they represent to our financial markets.
This articlepretty well describes this beast, which can be summarized as follows: CDSs are insurance policies on other securities. If securities owned by an entity go up in smoke through, say, the defaulting of a bond issuer, the securities owner can recoup the lost value from its insurer--the issuer of the CDS, or "counterparty."
The problem with CDSs, unlike insurance policies, is they are unregulated in every way you can imagine. The paperwork is minimal; there are no capital reserve obligations on the part of CDS issuers; worst of all, CDSs can be taken out by entities as "bets" on the portfolios of third parties. The example Forbes uses is imagine take out an auto insurance policy on your next door neighbor whom you know is a terrible driver, so you're sure to get money from his accident. Actually, CDSs are even worse because everybody on your block gets to take out an insurance policy on your neighbor's auto and get paid next time he totals his car.
Need I say more about 1) why so much money in these obligations exist? and 2) the nature of the threat if, in fact, these CDSs are actually enforced!