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People keep thinking that CDS are some sort of multiplier. They’re not.

CDS are absolutely a multiplier.

They have become the primary underlying capital of our financial system. They are highly leveraged. When times were good, and housing prices were rising, we gained tens of trillions of dollars of "wealth" on the balance sheets of most banks and other financial institutions. This mostly all happened in the last five years.

Now that real estate prices have gone down, even when they were down just a modest amount, this leveraging started working in reverse. Most banks and financial institutions, as well as some companies (GE, GM, Ford, ...), the GSE's, and many municipalities, states and our federal government are profoundly bankrupt.

The risk to the value of the underlying assets, our real estate, does not change; you're right on that. But three other ruinous things happen.

Through use of these CDS's, the risk is systemically interlinked, rather than isolated and firewalled. In a false effort to reduce risk, they disguised and obfuscated the risk. Now when one company goes down (e.g. Lehman) a chain reaction rapidly places numerous other companies in bankruptcy, whether they choose to acknowledge it right away or not.
Because the risk was obfuscated through excessive use of these non-transparently priced CDS's, it left each individual party (such as the loan officer writing a "nothing down, no income, no job, no assets, optional payments" mortgage on an overpriced piece of junk, or the hedge fund trading desk wizard, or the investment bank CEO) ignoring even extreme risks to game the system and earn more money. Normally, the "school of hard knocks" will teach those take on too much risk by taking them down, leaving the rest of us glad we were more cautious. This changed, so that everyone succeeded (bank failures were at all time lows the last few years), until everyone failed, catastrophically. Together we stand, together we fall.
The enormous leverage was used to fund our huge deficits and debts, as a basis for supposedly secure dollars, Treasuries, MBS's, stocks and bonds, which is now held by the largest nations and banks around the world, who are getting a trifle annoyed that the AAA paper they hold is junk of rapidly declining value.

The essential thing that CDS's multiplied is our exposure to the risk of a system wide failure. Instead of a variable stream of smaller failures, the only limit to this house of cards going higher was catastrophic collapse.

The other essential problem of CDS's, since they are not openly marketed and thus transparently priced (no one knows what they are worth), and since they became the absolutely dominant form of nominal wealth, is that they made the very foundation of our "money" supply non-transparent and untrustworthy.

The sterling, and then the dollar were once based in gold. Then the dollar became based on U.S.Treasuries, and the reliable income stream (from our IRS tax collections) for paying the interest. Both those formed an adequately solid basis for a currency. The essential property of any currency is that people can trust it as a store for value.

The world's reserve currency, the dollar (as well as the Euro) is now based on CDS's, which are more systemically corrupt and less transparent than the promises of our politicians.

We are trying to finesse this by bailing out the failing companies, which means replacing their failing paper with U.S.Treasuries. But this requires printing Treasuries far in excess of what the income stream from the IRS tax collections can fund.

The result will be that the value of the failed CDS's do not rise to the value of Treasuries. Rather, the value of Treasuries (and hence the dollar) will fall to the value of the failed CDS's, junk bonds, failed stock, and defaulted mortgages.

Time to stock up on the guns, ammo and whiskey.

Essentially, cheap mortgages, mortgage backed securities (MBS) layered thereon, and these CDS's layered on the MBS's, are the inflation that got us out of the crash at the end of the dot-com bubble.

Rather than directly inflate the currency that we were all tracking, we inflated these hidden financial instruments, and took advantage of the inherent lowering of prices for many goods thanks to newly industrialing nations (China) coming on line to hide this inflation.

We are now in a very volatile period, in which the money masters are trying to combat the enormous deflationary forces of this collapsing junk with an awe inspiring, but so far not yet adequate, increase in U.S.Treasuries.

We don't need to expand Treasuries one-for-one to match the collapsing CDS's -- thank heavens. That would mean somewhere between $50 and $100 Trillion, which is too big a number even for Paulson to dare ask for.

But we would need Treasuries of stable value in quantities of a few Trillion dollars, increasing our national debt from, very rough estimate, $10 Trillion to $15 Trillion. Holding the value of Treasuries anywhere close to par value, when this many new ones are printed, will be difficult. I am making my investments assuming a strong rise in U.S.Treasury interest rates over the next few years, as we saw in the inflationary periods of the 1970's.

If all the major counter parties (the other big nations which hold these Treasuries) decide to play nice, perhaps out of fear, then this might actually be sufficient to avoid collapse of the worlds reserve currency - our dollar.

Essentially the risk of systemic failure of the big banks has been elevated to the risk of systemic failure of the big nations.

In my personal behaviour, I am acting as if the odds favor this triage of the current monetary crisis happening successfully, after one to a few more years of pain and a recession, perhaps quite deep. But such a "successful" outcome is by no means certain. It could get a lot worse.

If, or when, the current international monetary scheme breaks down, it will likely devolve into a major war.

My top bet is that there will be one more big bubble first, in energy (oil, gas, coal, nuclear, solar, wind, geothermal, magic pixie dust, ...)