Company A issues a bond.
Company B places a bet that Company A will default on the bond.
Company C takes B's bet and similar bets from lots of other companies.
Company C books enormous profits on the business.
Company A defaults on the Bond.
Company B is rich.
Company C is up the creek.
Company B is rich.
Company C is up the creek.
Or, Company C has taken so many bad bets that it is unable to make good on the claim, and files for bankruptcy. Then:
Company A is up the creek (it must be since it defaulted on the original bond)
Company B is up the creek (no payment possible from C) and
Company C is up the creek also since it's now in bankruptcy from misjudging the level of risk on all the bets it made.
Jack
Company C takes B's bet and similar bets from lots of other companies.
Goes a long way towards explaining the downside market impact of CDS'. Unlike normal insurance, where the loss on the insured asset is limited to the asset value itself, the exposure of Company C is more like the exposure of a bookie - limited only by the number of bets they took.