Last night, NewsHour's chief economics correspondent did this story explaining what credit default swaps (CDS) are. He does it in an elementary fashion (using Looney Tunes at one point) making it a perfect in-class video. I highly recommend watching it. (60 Minutes also had a good one on Sunday, but I like this one more).
He did a Q&A on his blog afterwards.
There are an estimated $55 trillion in CDS out there. "Insuring" (they're not really insurance since insurance markets are regulated) all kinds of things from good debt to very bad mortgage-backed securities. No one knows how many banks are liable for how much and to whom. That's a large part of why we have this credit crunch.
After you watch the video, read this post about how the CDS are "undetonated ordinance." This is why firms are now too big to fail. If one big one fails and it results in a huge payoff to people who own a CDS on the firm, then other firms who issued those CDS will have to pay out and possibly go broke, and it will be a chain reaction. If enough of the CDS are insuring risky firms that are doomed to fail, then we're all doomed.
As the managing director of the SEC told Congress yesterday: "No one knows."