Lex has a theory about the way in which the CDS market can drive a vicious cycle in credit:
The pressure to hedge has led the most liquid contracts to overshoot, in effect pricing in absurd default risks and recovery rates. These same prices are then used as supposedly objective indicators to value the securities the CDS contracts were designed to hedge – hence the spiral of over-hedging and overstated marked-to-market losses.
It sounds vaguely plausible — but is it really happening? If you want to reduce your credit exposure, it’s certainly easier to buy protection in the CDS market than it is to try to sell illiquid cash securities. But with counterparty risk spiking upwards, CDS protection is less of a hedge now than it’s ever been. And when banks say that they’ve been deleveraging, I never get the impression that they’ve been doing that by keeping all their existing assets on their books and then just buying billions of dollars of CDS.
So color me skeptical, here. Which insitutions, specifically, have reacted to "the pressure to hedge" buy buying large amounts of credit default swaps? Once we get an idea of who they are, we’ll probably better understand whether that dynamic can drive down bond prices.