The credit default swap market is a modern Delphic Oracle. It speaks loudly and profoundly – these days at regular intervals – albeit using somewhat arcane terminology. And after major statements such as yesterday (or perhaps this week in general), it’s worth pausing to reflect on, and argue about, what it really means.

Thursday’s statement, to me, was about US banks (graph).

The risk of default for US banks, according to this market, is rising back towards levels not seen since mid-October. That is striking enough – but remember what has changed since then: (1) the G7 promised not to let any more systemic banks fail, (2) Treasury has provided repeated recapitalization funds on generous terms, and (3) the Fed offers massive, nontransparent funding to anyone in distress. How can it be that the credit market still or again feels the risk of default rising so sharply and to such high levels?

The most plausible interpretation – and here I’m willing to debate what the Oracle meant exactly – is that people expect the government will force the conversion of junior bank debt into equity. The treatment of private preferred shareholders at Citigroup, last week, is seen as the harbinger of further losses for investors.

In a comprehensive systemic clean-up approach and complete recapitalization approach, debt-equity swaps could potentially play a sensible role, particularly in countries without the fiscal capacity to sustain guarantees of all bank liabilities. But if they are done in chaotic crisis mode – as the government appears to be signalling – the additional damage to confidence around the world will be huge.

The events of mid-September 2008 were traumatic and awful to behold. I saw that trailer and I don’t want to see the movie. But it is exactly into that scary future that we now head.

It’s never too late to change policy, to make a difference, and to turn things around. But it is already very late.