As the world markets plummet on MLK day here in the States, the worst-case scenario that I have worried about for a few years now seems like it may be starting to unfold.

For those who haven’t spoken to me on the topic, the basic idea goes like this:

When people enter CDS contracts, most of the time they don’t do much work on their counter-parties in terms of evaluating their credit. In other words, much like when you or I get flood insurance for our homes we don’t ask our insurance company for its financial statements to make sure they will have the cash if we need to draw on it, people who bought default protection in the CDS market often did not evaluate the credit-worthiness of their counterparties.

Some suggested to me over the last few years that this was not necessary because the entities they were trading with were AAA rated, or that they were AAA rated subsidiaries of other entities.

As it turns out, there was counterparty credit risk in these contracts, and it is starting to materialize…and the repercussions may be massive as the counterparty is unable to make good on his side of the insurance contract (for more on CDS, see my earlier post here: Crazy Derivatives Stuff).

Doomsday happens if banks have to step in and make these contracts whole because they were market-makers in facilitating the trades. Haven’t seen this piece of the pie emerge yet, so I am hopeful it does not. But being forthright about exposures has not been high on the list of qualities of U.S. financial institutions of late.

It appears that one institution alone, discussed here by Bloomberg, has more than $60B in CDS exposure that it just “can’t pay”. In other words, it is like you paid your insurance premiums on your flood insurance and then Katrina hit and Bam – they didn’t pay…and not because it was “wind” damage ;-).

ACA Customers Allow More Time to Unwind Default Swaps

The problem with this is that we are only the the beginning of the default cycle and if there are already these kinds of issues, this may set off a waterfall effect as commercial real estate, credit card and autoloan ABS, and corporate loan defaults start ticking up.

In other words: we ain’t seen nothin’ yet.