I’m paraphrasing James Hamilton here.
A credit default swap is a contract that pays out if a specified event occurs on the underlying security. Normally, and in this case, the security is some debt and the event is a default on that debt.
There was a pile of $29 million in debt. Specifically, they were (based on) subprime loans in California and a bunch of them were already delinquent.
A brokerage firm from Texas started offering (i.e. selling) credit default swaps on the $29 million. Since so many of the underlying loans were delinquent, it seemed a sure thing that a default would occur and the big boys in New York were happy to buy the CDS contracts. In fact, they were so sure that the debt would default that they were willing to pay up to 80 or 90 cents for a $1 payout in the event of a default.
Two important things then played a role: First, credit default swaps are traded “over the counter”, so if you buy one from me you don’t know how many other people have also bought from me or how many they each bought. Second, there are (currently) no regulations on credit default swaps and in particular, there is no limit to the scale of the CDS market against a particular asset.
In this case, the big banks paid about $100 million for CDS contracts that would pay out $130 million if the debt defaulted.
The brokerage firm took the $100 million, paid off the debt entirely (so it didn’t default) and walked away with $70 million.