Investment grade and junk bond defaults may hit $500 billion of credit default swaps, triggering losses of $250 billion, Pacific Investment Management Co.’s Bill Gross said in commentary posted on the company’s Web site today. Gross characterized much of modern finance as “shadow banking system” that “dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.” Highlights from the rest of the commentary:

… CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks … The unfairly “Ben Stein pilloried” Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, “The drag on economic activity could be substantial.” Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.