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Matt Levine is a Bloomberg Opinion columnist. A former investment banker at Goldman Sachs, he was a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz; a clerk for the U.S. Court of Appeals for the 3rd Circuit; and an editor of Dealbreaker.
Credit default swaps have two related functions:
Thing 1 sort of works by backward induction from Thing 2: As the creditworthiness of the issuer goes down, it becomes more likely that the CDS will trigger, which makes it more likely that CDS sellers will have to pay CDS buyers, and in broad strokes the auction process in Thing 2 means that the sellers pay buyers more the worse things end up being for the issuer.
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