What is a Credit Default Swap?

Simply put, it's insurance for a debt.

Example:

I borrow $10,000 from Bank of America. Bank of America enters a contract with Wells Fargo saying that Wells Fargo will pay $100/month (I'm making up numbers, I don't know what the typical figures are) to them to buy this credit derivative and if I default on my loan then BOA has to pay $1,000 (again, I'm making up the numbers and they may not be proportionate) to Wells Fargo.

It is what caused the financial meltdown. It was pushed by bankers to have risky certificates insured. Former Texas Senator Phil Gramm, a professor of economics at the University of Texas A & M nicknamed 'Aggies', sneaked in 282 pages in a bill signed in 2000 by Bill Clinton that allowed Credit Default Swap. The bankers increased the leverage, a term used to indicate a ratio of borrowed money to down payment or actual cash = loan/cash. They had the Net Capital Rule changed from 15:1 to 33:1 i.e. they could make loans of $33 to $1 (depositors' cash). The bankers were risking depositors' money. The $32 is created money by the bank. If the bank made loans to 33 people of $1 each and if one of them declares bankruptcy the depositors' money is lost and the bank is bankrupt as the law requires that the bank has to have that $1 at a hand in case the depositors want to withdraw the money.

The bill also enabled mergers of banks so banks could also make mortgages to home buyers. Many mortgages were sold to people who couldn't afford it or 40-years mortgages where people lost their jobs owing to outsourcing of jobs overseas. These bad mortgages or loans were changed by banks into certificates and sold as investments to other banks. The banks insured them to reduce the risk to themselves. The mountain of debt exploded when the mortgages defaulted i.e. the home buyers couldn't make the monthly mortgages payments. Those certificates turned from assets (investments) to liabilities (loans) so the banks' balance sheet were screwed up. They didn't have enough capital. The insurance companies also went belly up as the mortgage based certificates insured were in the trillion of dollars, about $45 trillion.