Hold tight! We're heading for a new credit crash

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. As the G7's central bankers and finance ministers meet in Marseille today, here is some food for thought.

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 in July cannot be implemented. The sticking point is a demand for collateral for the second bailout package. Finland sought and got 500 million in cash as security against its 1.4 billion share of the second bailout package.
Hearing of the ill-advised side-deal between Greece and Finland, Austria, the Netherlands and Slovakia are now also demanding collateral. Of course, Greece does not have two euros to rub together and would need to borrow the collateral.
A disorderly unwinding of the Greek debt problem cannot be
ruled out. Ireland and Portugal remain in difficulty. Spain and Italy are also embattled, with only European Central Bank 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 ones, 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 more than $2 trillion. French and German banks have huge exposures.
If there are defaults, these banks will need capital, most likely from their embattled sovereigns. European banks shares have been hammered, with French bank
Société Générale's shares falling nearly 50% in a short period. Deutsche Bank's head fears many smaller banks may not survive sovereign defaults.
In the US, concerns about Bank of America have emerged, with analysts suggesting it requires significant infusions of capital. Its shares have fallen by about 40% in the past month. Its decision to issue $5 billion in preference shares to Warren Buffett's Berkshire Hathaway, now confirmed as the markets' lender of last resort, at distressed prices was a statement of weakness.

Fact 3: Money markets are seizing up

Banks and financial institutions are finding it increasingly difficult to raise funds. Spanish and Italian banks have limited access to international funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks. Banking leaders have admitted there is no functioning market for many banks to raise money at reasonable cost other than on very short terms.
US money-market funds have reduced their exposure to European entities. They have also decreased the term of their loans to as little as seven days at a time in an effort to limit risk. European banks are having 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.

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 such as China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. Slower growth also leads to currency instability. The Swiss National Bank has moved to stop money flowing into Swiss francs, seeking a safe haven, crimping growth and hindering the ability of Swiss exporters to compete. The currency intervention may trigger tit-for-tat retaliation, further affecting growth.
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, causing further tightening in lending conditions and the cost of finance. The rapid and marked deterioration in economic and financial conditions means the risk of a serious disruption is now significant.

If markets seize up again, this time it will be different. There may not be enough money to bail out everyone and every country that needs 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 costs. Unconventional monetary strategies, such as quantitative easing, have been tried with limited success. Further doses may not be effective.

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

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk