Please never forget about one of the biggest elephants in the room – credit default swap market. The total notional value of CDS outstanding is estimated to be $43 trillion. So far it’s only a notional value, but who knows what happens next. Let me remind how CDS works.

Every new CDS contract is created by the bond underwriter and is initially priced at 100%. The insurance seller (usually a hedge fund) will assume the default risk and starts receiving the coupon payment. There is no money changing hands when the first sell is made. If the contract gets down in price to, say, 99% then the insurance seller need to pay 1% to get rid of the contract to another hedge fund that agreed to assume the risk.

Now there is a question of margin. The clearing system is watching the price changes in each contract, assuming they trade frequently, and is requiring additional margin every time the contract is losing some value. It is not much different from short positions. You can think about it as a big short market with $43 trillion outstanding notional value that tracks prices that move in a direction opposite from the corporate bond market.

And CDS do change in price now. Posted at the Mish blog, here is the GMAC ResCap CDS (priced as spread):

rescap cds

Most homebuilders are also experiencing the CDS failure, check charts here.

The whole system works only because the market is very liquid, prices are quoted several times per day and margin calls are calculated and met promptly. When the default expectations are low this whole $43 trillion market could be traded with only $200 billion of liquidity and remain properly capitalized. You can think about CDS as of flying butterflies, they are very light and pretty.

Let think what happens when the recession comes. From Spring of 2000 to Spring of 2003 the junk bond market lost 35% of price (check SHIAX chart). If the CDS market will ever lose 35% of its value it will amount into $15 trillion of capitalization required to maintain its liquidity.

I’m sorry, but there is no $15 trillion in that system to float the CDS market! We probably can collect that much is we sell 90% of the stock market, or crush all commodities to historic lows, whatever it requires. My gosh, there is only $4+ trillion of treasury bonds out there. Even if we sell all the treasuries we still need $11 trillion more for that margin call! Wait a minute, did it happen before?

Yes it did. In 1931 the treasury market unexpectedly collapsed (it happened during very short time) from the yield 2% up to 6%, the 7-year maximum. Of course it was a buying opportunity of a lifetime, because rates went back to 2% in 1934 and then below 1% in 1940s.

This spike happened not because of any inflation expectations, it was a deflationary environment. Not because of any worry about Treasury solvency – they had all the money to service the debt, and the debt was quite small. It happened because it was a severe credit crunch and there was not enough money in the system to buy treasuries at that fantastic discount. Nobody had any damn money!

I think that when the CDS market will finally start to move (it will take time, it’s a huge market) it will drain trillions and trillions of liquidity, like a giant sponge. It will require a huge sell-off in all the markets to fill the margin calls, the stocks, bonds, commodities – they all will have to go down big time, just to fill the gap.

That will be a deflationary environment of the Kondratieff Winter