Very Serious Consequences Are Now Inevitable - Events Are Moving Quickly

Recent events have unfolded at an extraordinary rate - there has been a palpable sense of impending disaster in the financial markets - which has fuelled a vicious reaction, both in terms of extreme market volatility and a precipitous destruction of value.

In the author's view - we are now past the point of no return - there are now going to be serious and widespread consequences, both in the 'virtual' and also in the real economies.

Other commentators are now drawing similar comparisons to those that we have made for some time - between the current situation in the UK (and elsewhere), and the events that occurred in Japan during the 1990s - see our article from December 2007: "We Don't Have Earthquakes in Britain".

We are also now entering a market environment where I believe that there is a very real chance that an unprecedented financially destructive phenomenon that we have previously dubbed as 'The Risk Soliton' might now be unleashed. This is a non-linear wave of financial devastation that could move between the world's financial institutions, largely travelling through the credit derivatives markets.

As of today, I would say the probability of this happening is now between 5% and 10% - see our earlier article: Could the Fall of Lehman Brothers Unleash The 'Risk Soliton' ?

In response to our article, the economist Prof. James Galbraith commented: 'The Metaphor is Excellent'.

Some Disturbing Food for Thought

To put recent events in context, it is worth considering a few relevant figures. There are many to choose from, and most of them are bad. So let's look at the current share capitalisations for 4 of the UK's major banks, shown in the table below:

We might compare these figures to the sizes of some of the 'risks' that are likely to be lurking in the world's financial system. The impact of the fall of Lehman Brothers alone in the credit derivatives market could well be in the hundreds of billions of dollars.

There would also appear to be a number of other pigeons coming home to roost. A recent report in the FT on October 8^th highlighted problems reported in the US due to huge syndicated loans 'going bad' - such loans are often associated with LBO activity.

The FT article 'Problem Loans Nearly Triple in the US' quoted a figure of $373 Bn of such loans facing actual, or potential, difficulties, at the end of the second quarter. It is worth bearing in mind that this may just be the tip of the iceberg if current trends continue, and UK banks have not exactly been reluctant to indulge in similar risky activities.

One does not need to do a very sophisticated analysis to see that these figures suggest that some banks are now potentially on rather thin ice.

Unfortunately, in our opinion, the plain fact is that there simply is not enough money at the disposal of the world's collective governments to fix these problems by brute force alone. Indeed, the fact that the resources of a country, although often huge, are still finite, is being thrown into sharp relief by the current plight of Iceland.

Managing Market Psychology

In our opinion, although very real and very significant measures are now required, a crucial factor is whether the world's governments and central banks are seen to be acting in a synchronized and co-ordinated way, and are seen to be managing the situation, and managing it together.

This would have to include both measures to stimulate the economy and reform the financial sector in a fundamental way. Also, where money is borrowed now to address the situation, it would need to be clear how and when it would be paid back.

The most significant feature of the recent 0.5% rate cut was that it was obviously a co-ordinated trans-national measure - if the same cuts (or larger) had been made in a piecemeal or staggered fashion, then the overall effect would probably have been adverse.

The situation is not helped by the fact that the credibility and authority, particularly of the US government, and to a lesser degree the UK government, is not exactly riding high at the moment. In addition - when Europe faced its last major test - although of a different sort - during the explosion of violence in the former Yugoslavia - it failed abysmally.

Assuming that a co-ordinated global strategy can be agreed and implemented - and that a semblance of calm, or possibly just a shell-shocked silence, can be restored to the markets for a sufficient period - then it is possible that some of the surviving heavyweight market players might return to the market. They would be looking for cheap buying opportunities, and undo at least some of the recent losses. This would, perhaps, enable the banks to manage their situations better, and ultimately enable the tax payer to get their money back.

So, If this is the Best Game in Town - What Might Go Wrong ?

One scenario that has to be quite a real concern - is that the governments and central banks will continue to pump in huge amounts of money to support the banks - and just as things begin to settle down, a huge skeleton will fall out of one of their collective cupboards with a crash - shattering the calm - and triggering another wave of panic and market value destruction, effectively wasting much of the money injected into the system on our behalf.

One hopes that, given the impact that such an event would have, the government have asked the banks for reassurance that there are no such skeletons in their cupboards that might derail the current plans to restore a stability.

Unfortunately - in the square mile at the moment - one can almost hear the creaking of straining cupboard doors.