Final answer:
A credit default swap is a type of financial instrument that acts as insurance against the default of borrowers by compensating the investor in case of default. These instruments, along with CDOs and high-yield bonds, were central to the expansion of the subprime mortgage market and the subsequent financial crisis.
Step-by-step explanation:
A credit default swap (CDS) is essentially an insurance contract against the default of one or more borrowers. They provide a way for investors to manage the risk of loss from default. Much like insurance, if the borrower defaults on their obligations, the provider of the CDS compensates the investor. This financial mechanism was at the center of the housing bubble and the subsequent financial crisis in the mid-2000s, where the securitization of subprime mortgages through collateralized debt obligations (CDOs) and related instruments like credit default swaps contributed to a rapid expansion in the availability of credit, often to borrowers with poor credit history.
Mortgage-backed securities were part of complex arrangements that distributed the risk of loss, with different investors agreeing to cover different layers of potential loss. This structure, coupled with high-yield bonds offering higher interest rates to compensate for higher risk, created a fragile financial ecosystem. Credit default swaps played a role by ostensibly offering protection, but when the housing bubble burst, CDOs and other investments associated with subprime loans suffered extensive devaluation, revealing the vulnerabilities of the system and leading to widespread financial instability.