Is a new credit crash looming?

In Crosstown Traffic, Jimi Hendrix sang: "Can't you see my signals turn from green to red / And with you I can see a traffic jam straight up ahead."

In global financial markets, the signals have changed from green to red. But rather than a simple traffic jam, a full-scale credit crash may be ahead.

Fact 1 - The European debt crisis has taken a turn for the worse

There is a serious risk that even the half-baked bailout plan announced on July 21, 2011 cannot be implemented.

The sticking point is a demand for collateral for the second bailout package. Finland demanded and got euro 500 million in cash as security against their euro 1,400 share of the second bailout package.

Hearing of the ill-advised side deal between Greece and Finland, Austria, the Netherlands and Slovakia also are now demanding collateral. Of course, Greece, which does not have two Euros to rub together, doesn't have this collateral and would need to borrow it.

A disorderly unwind of the Greek debt problem cannot be ruled out. Ireland and Portugal remain in difficulty.

Spain and Italy also remain embattled with only European Central Bank (ECB) purchases of their bonds keeping their interest rates down. Concern about the effect of these bailouts on France and Germany is also intensifying.

Fact 2 - Problems with banks have re-emerged.

Banks globally, especially European banks, are seen as increasingly vulnerable to European debt problems.

The total exposure of the global banking system to Greece, Ireland, Portugal, Spain and Italy is over $2 trillion. French and German banks have very large exposures.

If there are defaults, then these banks will need capital, most likely from their embattled sovereigns. French bank's Societe Generale's share price has fallen by nearly 50 per cent in a relatively short period of time.

In the US, concerns about Bank of America (BA) have emerged, with analysts suggesting that the bank requires significant infusions of capital.

The major concerns relate to BA's investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.

BA shares have fallen by roughly 40 per cent over the past month, compared to a 15 per cent decline in the S&P 500.

BA's decision to issue $5 billion in preference shares to Warren Buffett's Berkshire Hathaway, now confirmed as the market's lender of last resort, at distressed prices was not a statement of strength but weakness.

BA's woes confirm that problems in the banking system exist globally, not only in Europe.

Fact 3 - Money markets are seizing up

Banks and financial

institutions are finding it increasingly difficult to raise funds. Costs have risen sharply.

Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.

Over the last few months, US money market funds have reduced their exposure to European entities, especially Spanish and Italian banks.

The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as seven days at a time, in an effort to limit risk.

European banks have to pay higher interest rates, if they can attract funds.

As a result, non-financial institutions are finding finance less readily available and more expensive, recalling the credit problems of late 2008/early 2009.

Banks are increasingly following Tennessee Williams' advice for survival: "We have to distrust each other. It is our only defense against betrayal."

Fact 4 - The broader economic environment is deteriorating

The global economic recovery is stalling. The risk of a recession or minimal growth is significant. Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing.

Then there are pernicious feedback loops. Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing.

Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance.

The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.

If market seize up again, then "this time it will be different". There might just not be enough money to bail out everyone and every country that may need rescuing.

Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns.

Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies - namely printing money or quantitative easing - have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

The global economy may muddle through if policy-makers make the correct decisions, but a second credit crash is now distinctly possible.

The trigger and timing is unknown. As John Maynard Keynes remarked: "The expected never happens; it is the unexpected always."

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)