Why is a Credit Default Swap where the buyer does NOT own the credit instrument not legally gambling?

it's not gambling. it's just high risk investing.

gambling relies entirely on chance - if you're using anything other than luck in a casino, it's cheating.

in financial markets, you aren't relying on chance and luck - you have statistical models and rules.

I have heard others asking the same. It is like naked shorting where you are "selling" stock you don't own or have not even "borrowed" to sell.

I don't know exactly how to think about this. Options and futures get a bit of a bad rap and the blame for things.

At times of great volatility they are as much as a calming effort as a driving force. When "bets" go bad, say on an instrument going up, then those that bet against it take the losses and this covers part of the fall.

One problem with the mortgages is that they used the "insurance" of the credit default swaps to give the mortgages higher rating than they should have had. The risk was much higher than they figured. And those that insured them with the CDS's didn't have the money to pay off on the insurance. So in a sense it didn't work.

This is why they bailed out AIG. It was because the losses that AIG was taking was owed to the banks. If AIG failed and couldn't pay off the banks that would have brought down the banks.

The REAL stupid thing they were doing was as a "Swap" they were insuring mortgages using mortgages as their reserves. So when they fell it not only trashed the mortgages but the companies didn't have the money to pay off on the insurance either.