A dollar default is unthinkable in these affluent modern times. Or is it?

Last week a “flight to safety” of investors in America’s $3.5 trillion Treasury money market was only halted by Secretary Henry Paulson’s swift action in nationalising the banking sector’s bad debts.

Read The Great Harvard Sausage Scandal 2008 over at Syntagma.

Of course, most of the movers and shakers have already salted away their massive bonuses and are probably even now relaxing with a cocktail or two on their yachts in Monte Carlo harbour.

They have left us with a colossal mountain to climb. In the UK, house prices have a further 25-30 percent to fall, according to Roger Bootle, and already Britain’s largest mortgage lender, HBOS, has failed. How many other banks will go before we hit bottom?

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Can we really have witnessed the demise of three top investment banks in so short a time? Bears Stearns, Lehman Brothers and Merrill Lynch have all disappeared off the radar in quick succession.

What is happening to the world’s — and especially the American’s — financial system?

It started with the slicing, dicing and splicing of U.S. mortgages of sub-prime customers. The structured financial instruments that were sold off around the world became known as CDOs (Collateralized Debt Obligations).

They have poisoned the world’s financial system, like seeping toxic waste. Now a new danger is forming on the horizon.

CDSs (Credit Default Swaps — insurance policies for bonded commercial IOUs), which are out there in their trillions and trillions, are beginning to crumble in the face of massive defaults.

The world’s biggest insurer AIG is already in Lehman territory — its shares plummeted by 70 percent in early trading yesterday. The long-foretold CDS crisis is with us at last.

So what precisely are CDSs and how will their demise affect most of us in coming days, weeks, months and years?

George Soros estimates that the value of CDSs now equals half of U.S. household wealth, an almost unimaginable number — let’s call it $23 trillion.

CDSs are hedges made by investors in case a company defaults on its debts. In effect you bet on a company failing to protect your investment in the event it does just that. The problem arises when large numbers of companies go bust and the CDSs themselves become worthless since no-one can pay them out.

A CDS seller undertakes to compensate a buyer if a corporate bond defaults. Since there is no limit to the size of cover taken out, the value of CDSs often exceeds a company’s debts. Moreover, many CDSs are bought with borrowed money so the infection of the system drives deep into the financial heartland like veins in a blue cheese.

The danger now is debt deflation: a rapid reversal of debt issuance, or deleveraging as it is called.

Tim Congdon of the London School of Economics says, “Banking system capital is being wiped out. The risk is that this could lead to a contraction of credit and set off a self-reinforcing downward spiral, leading to the sort of debt-deflation we saw in the 1930s.

“It is already clear that money growth has ground to a halt over the past three months. We must prevent it from actually contracting. If the Fed and European Central Bank don’t cut interest rates soon, it is going to be a problem.”

The Bank of England’s rigid inflation target, set by Gordon Brown when inflation was low, is now a millstone round Mervyn King’s neck at a time when energy, food and commodity price rises are being imported from global markets.

The Eurozone is similarly caught in a time warp relating to Germany’s neurotic fear of hyperinflation. Add the growing divergence between euro economies and a far deeper than necessary downturn is guaranteed for Western European countries.

America is already suffering a double blow: the fading of the effect from the summer tax stimulus and a loss of export competitiveness as the dollar rises.

What began as bad government, worse regulation, grasping banks, financial structures that lacked resilience because they were built on sand, have left us with a perfect storm that is about to come ashore and swallow large parts of the economy.

Jonathan Pierce at Credit Suisse — itself in the wars over structured debt obligations — thinks that Barclays is facing a near £10 billion ($20bn) of losses if it follows Royal Bank of Scotland in adopting a conservative estimate of its mortgage assets.

RBS declared £5.9 billion ($12bn) last week and has opted for a £10 billion request for cash from its shareholders.

Barclays will, we understand, keep its losses confidential.

It looks like blue-chip Barclays will be the next major bank to announce a rights issue, or look for outside investors, possibly from the sovereign wealth funds of the Middle East or Far east.

Yet another huge loser in the American subprime mortage market is set to announce big writedowns next week.

Royal Bank of Scotland (RBS), Britain’s second largest bank, is understood to be seeking to raise capital from its shareholders in a rights issue thought to amount to £10 billion ($20bn), which is probably the biggest rights issue ever demanded in the UK.

The bank, which bought troubled NatWest and ABM Amro, has been running on low capital ratios for quite a while. It also has major exposure to subprime debt instruments. It has been linked with Spain’s Banco Santander for many years.

When such a major player is caught short like this, it brings home the extent and depth of the crisis in transatlantic financial markets, with all the knockon effects to the rest of the world.

Vince Cable, a spokesmen on Treasury matters who carries more weight than the Treasury these days, believes all the banks should follow the example of RBS, since they will need a great deal of liquidity from the Bank of England and that should be underwritten by shareholders, not taxpayers.

We await next week’s announcement, which will surely be leaked over the weekend.