World leaders have had a busy weekend as they attempt to come up with a coordinated way to inject liquidity and a measure of confidence into the world financial system. The leaders seem to have their own financial panic of 2008 underway as they feel the need to quickly act and do something but don’t seem to have any better idea as to what to do than you or me. How comforting.

Leaders from the G-7 and G-20 nations as well as the IMF are all discussing what should be done to at least slow down the world wide bleeding. The great challenge is that the de-leveraging process now underway discloses in a very nasty way just how far off course the world financial system, lead by the irresponsible people in the United States of America government, was over the many years of deregulation, poor oversight, and bubble creation.

Smart people who really should have known better acted as financial asset cheerleaders as asset values skyrocketed under the influence of easy cheap financing. As long as values kept increasing the big shots on Wall Street, on The Street in London, and elsewhere added increasing amounts of leverage. So we had leverage stacked on top of leverage and the regulators didn’t seem to notice how dangerous the game had become. It never seemed to occur to anyone that asset values may fall one day and continue to fall for many years. No one thought that a decline could occur in almost every asset class and in every market of the world, all at the same time. So much for the safety of global and asset diversification.

The use of excessive debt and financial leverage had to lead to trouble. Just as values explode on the upside they implode on the downside. In the closely knit world community of financial enterprises the failure of one major institution leads to the failure of another, and then yet another. Credit freezes up as banks fear of lending even to each other, fear that they may not have money returned from previously financially strong counter parties, and stop lending to even strong credit worthy customers.

As assets values fall the entire Ponzi scheme of building a financial system that must have ever higher prices to survive comes to the ground like every Ponzi scheme ever created eventually does. With leverage as high as 40 to 1, unbelievably employed by investment banks and some hedge funds, it doesn’t take much of a decline to completely strip out every cent of equity. A 2.5% decline will do it, thank you very much. Positions that were thought to be safety hedged against declines become outright naked positions when your counterparty goes under.

In addition, it is a sad fact that bubbles built on the backs of assets that are long term assets, like housing and commercial properties, are especially difficult to control on the downside. Once the real estate bubble pops it takes a very long time for real estate markets to recover. The real estate cycle is long. Once markets have been saturated and the downward spiral is underway it will likely take years, probably much longer than you and world leaders now expect, to recover. And the troubles caused by the decline of real estate values, as we are now finding out, spills over in the general economy at an alarming rate.

But what now financial warriors?

My best guess is that we are all in for a long painful emergency. The downward economic cycle will have to run its course and will strongly resist the efforts of the Fed, the US Treasury, G-7, the IMF, the Japanese Central Bank, all the efforts of Euroland, and every other government agency to stop and reverse it. Events are now out of control.

The emergency actions that the various governments of the world are taking will probably make things much worse. For one thing we can expect a lot of re-regulation. Plus in the US a lot of socialization has already taken place with the federal government bailout of Bear Stearns, Freddie Mac, Fannie Mae, AIG, probably soon enough GM and Ford, and the taking of equity positions in banks.

Think about it. The re-regulation of the financial services industry will more than likely take all of the fun and juice out of the industry for good. Capital tends to move where it is treated best. The US will probably shoot itself in the foot and drive tremendous amounts of financial services related capital offshore. There will be safe havens, like perhaps Singapore, that will see a flood of capital in flows as re-regulation fever takes hold in America and Europe.

Once the regulators get underway there will be no stopping them. While a review and revision of regulations is certainly in order you can expect an industry overkill. And who in their right mind can believe that the government which is largely responsible for this mess is going to do a stellar job at managing the complex businesses that they now have an equity stake in?

So I for one don’t expect too much if any relief will be generated by the panicked world leaders of 2008. It is a time to raise cash, reduce your burn rate, and not be too early in jumping back in to markets because they seem cheap. We have already seen that a cheap Lehman Brothers stock became just about worthless. In the present environment cheap will be defined as zero for many long standing previously successful companies. But in bankruptcy cheap becomes worthless so beware of cheap.

It is a time to hunker down in your bunker and to protect whatever you may have left for times that may soon become far worse. The meltdown of the world financial system has started and there are $56 trillion of largely worthless yet still vastly overvalued derivatives to go. That is a lot of money that may largely disappear. It is more than all of the governments of the world can handle.

If you're new here, you may want to subscribe to my RSS feed. Thanks for visiting!