Derek,

It may be an Orange County-style mess, but I kinda doubt it will lead to utter collapse.

Credit default swaps are potent instruments, but they could actually mitigate the problem. Here’s how.

If we return to our example above: the bank has a $100M loss on a failed hedge fund. If the bank has to absorb the entire failure, it has to dump $1B of assets. But if it has hedged this risk by swapping pieces of the default risk with others, it could be better off.

Say it swapped the default risk on that $146M loan with 20 other institutions. In that case, each institution would lose $5M. This may be small enough to not cause much of a regulatory problem by itself. For some banks it might, but now they only has to sell no more than $50M worth of assets each, which is much easier to do in short order than dumping $1B.

So, effectively CDSs spread the risk across multiple institutions, so you have a much bigger equity pool to absorb defaults.

Now, if the TOTAL defaults in the market are too big, you have a REALLY big problem, because this triggers a simultaneous cascade at all institutions. This is, I believe, the problem the government faced with AIG, although there’s probably no way to know at this point. But it may have been better to stop the cascade at the bottleneck.

Where our big risk exists is in a sudden and deep recession that pushes wages down fast. This is where illegal immigration actually may cushion the blow; if we experience significant reverse migration, we could see lots of short-term layoffs but not a lot of wage compression. Demand will fall, but so will supply. Total employment will fall, but unemployment will be stable. People might have to take a slightly lower paying job, but businesses will not have a big pool of workers (with immigrants gone), so wages won’t move too much. This will really help the mortgage mess, since wages are really the cash flow stream that backs mortgages.

Anyway, this may all seem hopelessly optimistic, but there it is.

L3