CDSs work like this: Imagine you buy a house, and then you take out fire insurance with AIG in case it burns down. You pay AIG a premium for the fire insurance. They pay you a large lump sum if the house burns down. Now imagine that AIG felt the risk of the house burning down was so low that they sold insurance policies on the same house to 100 people. They're making tons of money on premiums. And now imagine they did this for 100 different houses. They're raking in the profits, investors are loving it and AIG is doing well. And now imagine all the houses burned down at the same time...
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CDSs work like this: Imagine you buy a house, and then you take out fire insurance with AIG in case it burns down. You pay AIG a premium for the fire insurance. They pay you a large lump sum if the house burns down. Now imagine that AIG felt the risk of the house burning down was so low that they sold insurance policies on the same house to 100 people. They're making tons of money on premiums. And now imagine they did this for 100 different houses. They're raking in the profits, investors are loving it and AIG is doing well. And now imagine all the houses burned down at the same time...