On December 21 I wondered whether the employment numbers were indeed trending toward something consistent with a recession.  I hedged myself a bit by saying that my analysis used rather rudimentary data, and that of course the economy is far more complex than what can be described by some statistical changes as interpreted by yours truly.

The funny thing about markets however, is that seemingly marginal data can morph into a driving force if enough people start focusing upon it. That’s why I found it interesting that on January 4 Barry Ritholtz’ excellent blog also discussed the Birth-Death issue I raised in my December piece.  In Saturday’s edition of John Mauldin’s “Thoughts From The Frontline”, Mauldin too revisits the same topic. Lastly, on Friday, during one of his reports from the floor, CNBC’s Rick Santelli noted that the Birth-Death Model numbers were catching the attention of traders.  Again, by itself the issues raised by the B-D Model are just one piece of the puzzle, unless of course the crowds make it the piece of the puzzle.

I note this because a far more ominous potential problem is beginning to bubble to the surface.  That is the issue of who is on the hook for having underwritten Credit Default Swaps (CDS) for many multiples of the underlying debt, and how these entities will make good on these CDS.  For those new to CDS, they are basically put options on debt.  If a corporate bond (or other debt obligation) covered by a CDS defaults, those who underwrote (read: Sold) the CDS must pay off those who bought the CDS.

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• The amount of issuer’s debt outstanding
• Minus the recovery on the debt
• Times a multiple between likely between 5 and 10
• If we assume even a 5% corporate bond default rate, and a recovery rate of 50% on those bonds, it means that after the CDS on those bonds are paid off, the impact to the financial system would be tantamount to a 12.5%-25% default rate on all outstanding corporate bonds; enough to put the entire financial system on the brink.

Why raise this apocalyptic scenario now, considering that corporate bond default rates in 2007 were at historic lows, well under 1%?  In a Friday Buzz I pondered if the behavior of the financials is hinting to a “nuclear size cockroach” about to jump out of the woodwork.  This is a weekly chart of the Banking Index (BKX) going back to 1999.


Click to enlarge
(You can see many other similar charts in Prof. Shedlock's piece An Asymmetrical Unwind of the Credit Bubble)

Forget about support and resistance levels, retracements, entry points/stops, overbought/oversold, and all the other technical stuff, and just look at the picture.  The stocks of the largest financial institutions on the planet, Citigroup (C), Bank of America (BAC), Wachovia (WB), Wells Fargo (WFC), JP Morgan Chase (JPM) – the institutions where money for our finance-based economy lives – are showing extreme distress, more so than at any other time including ’02, when the market was in free fall; and back then, debt derivatives (CDS) outstanding were a fraction of what exists today.  What’s even more worrisome is that the CDS on these banks’ debt seem to be confirming such level of distress.

I understand if some readers might dismiss my concern (not belief yet – but definitely concern) that we may be on the verge of something worse than just a recession. But once you have dismissed my worries, please do yourself a favor: listen to Friday's video interview with UBS’ Art Cashin.  For those unfamiliar with Cashin, he is the NYSE floor director  for UBS, a man with decades of experience, and whose commentary consistently adds more to my financial education than just about any of the reams of research I read every day.  Watch the whole thing (it’s only 3-4 minutes), but listen carefully to what he says from the 2:20 mark on.

Then store his words in your memory bank, and put your antennas up to hear if his worries are expressed in other circles.  As I said at the beginning of this piece, crowds can take a “piece of the puzzle” and make it “the piece of the puzzle”.  If Cashin’s fears start spreading, the real “fun” is still ahead of us.