What we've discovered is that the real problem is bigger. Large parts of the financial system are too thinly capitalized and too dependent on unreliable short-term debt. Leverage ratios often reached 30-1 for investment banks and hedge funds ($30 of debt for every $1 of capital). The presumption was that the MBA types had learned how to "manage risk". That false conceit backfired. Low capital didn't adequately protect against losses. Confidence and trust evaporated, because no one knew which institutions held suspect securities, how much the losses were and who was ultimately safe.

    "Deleveraging" - a shift from excessive debt toward more capital - is inevitable and desirable in the long run. The trouble is that, in the short run, it may destabilize the economy if it proceeds too rapidly.

    Consider stocks. Their plunge has been driven in part by hedge fund selling. Hedge funds often buy stocks by borrowing from their "prime dealers" - firms like Goldman Sachs and Morgan Stanley, which in turn borrow from commercial banks. If banks "deleverage" by reducing loans to prime dealers, then prime dealers tighten up on hedge funds, which react by selling stocks. "It's a big piece of why the stock market is down," says Michael Decker, former chief economist for the Securities Industry and Financial Markets Association and now co-head of the Regional Bond Dealers Association.

    All around the world, we see variants of this cycle. The yen "carry trade" - borrowing at low interest rates in Japan and lending at higher rates in other countries - is reportedly contracting. Iceland's main banks have been nationalized because they couldn't renew their short-term borrowings.

    But if credit is withdrawn too abruptly, the prices of stocks, bonds and other assets that it propped up - and also the real economy of production and jobs - will fall. And the effects feed on themselves.

    Hedge funds, for example, have been hit with high redemptions from investors: about 5 percent in September, two and half times normal, says Charles Gradante of the Hennessee Group. These compound selling pressures.

    The present challenge is far more complicated than merely quarantining dubious mortgage-related securities. What's involved is a fundamental remaking of the global financial system, from one that was inherently fragile to one that rests on firmer foundations. But if the change proceeds too quickly and haphazardly, it risks a hugely destructive credit implosion.

    All the policies undertaken so far will ultimately be judged by whether they succeed in managing the transition and restoring confidence in financial markets that self-correct naturally - as opposed to submitting to the continuing mayhem of uncontrolled "deleveraging".

    (Source: China Daily)