The idea of a credit default swap was something like insurance. If you as a business owned bonds or stock in a company and you thought it was likely to fail, you could purchase a credit default swap for a certain percentage of the stake you had annually. If the company did indeed fail, the company you paid would buy your now worthless stocks/bonds for the value they were worth when you entered into the arrangement.

The problem arose when people like AIG would agree to protect someone who didn't actually own any stake in the company at all. AIG would get some money from these less-than-ethical hedge fund managers to protect an investment they didn't own. At this point it stopped being insurance and became more like gambling with better odds.

Imagine someone taking out a life insurance policy on a complete stranger (or company in this case) and then having four other people take out life insurance policies on that same person. Should the person die (or the company collapse), the insurance company has to pay out large sums of money multiple times to multiple parties, sometimes in excess of what the company was actually worth. That is how hedge funds would profit from credit default swaps and how their excessive use made a bad situation even worse.

Now to answer the second part about the housing crisis. The housing crisis actually came before the credit default swap stuff. At its core, the subprime mortgage crisis was caused low Fed rates, an obscene demand for decent investment opportunities, and by separating the risk of a mortgage from its value, but it's a long way to explain how we got there.

With the rise of emerging markets in the Middle East and Asia, there was a rise in demand for investment. Normally, large central banks and monetary funds and similar gigantic holders of trillions of dollars were extremely cautious about where their money was invested and usually put them in extremely safe, slow growth things like treasury bonds. In the early part of the decade up until 2006, there was a glut of money coming in to be invested but only the same amount of safe places to invest. At the same time this glut of money was coming in, the Fed kept their interest rates extremely low, so these people went looking elsewhere to invest in to get a better return.

One of the places they looked to invest in was the housing market. However, individual mortgages are way way WAY too small potatoes for these investment firms to deal with. So, someone decided to buy hundreds or thousands of mortgages from banks and bundle them into what was called a mortgage backed security. They would then sell off "shares" of this security to these giant investors, and the giant investors went crazy over them because they were getting 5 to 6 times the return that they were getting from the Fed.

Because demand for these securities was so high, more and more mortgages were required, so banks were encouraged to loan money to riskier and riskier clients. It got so bad that banks started handing out half million dollar NINA loans. That stands for "No Income, No Asset." Yes, demand for mortgages was so high that banks were giving people money without checking to see if they had a job, and without checking to see if they had any money saved. Of course, the banks had absolutely no reason to sure these people were actually able to pay their mortgages because they were selling these mortgages up the chain before the ink dried, so they got all of the money and none of the risk.

That is, until the giant investors at the top suddenly lost their appetite for these terrible terrible loans a couple years later once all the foreclosures started coming in. Once this happened, everyone all through the chain got stuck with a lot of bad loans that people couldn't pay.

So, there's my ridiculously long explanation of what caused the risks of housing default to escalate so high. The links I've provided are very good at explaining this. I've provided links to both the audio and the transcripts.
Source(s):
http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1263
http://www.thisamericanlife.org/extras/radio/365_transcript.pdf
http://www.npr.org/templates/story/story.php?storyId=96333239
http://www.thislife.org/Radio_Episode.aspx?episode=355
http://www.thislife.org/extras/radio/355_transcript.pdf


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