U.S. Federal Reserve Headquarters (Flickr: NCinDC)

The complex structure of modern capital markets is increasingly the cause of financial crises. External shocks like a decline in housing prices are intensified as they move through the convoluted chains of dealings that link market participants. Concentration of trading among a small group of dealers only heightens the many risks.

In hindsight, the Federal Reserve’s decision not to bail out Lehman Bros. was a major miscalculation that helped generate the wave of financial anxiety, distrust and uncertainty that doomed American International Group and other institutions. It also helped freeze up credit markets that are only now beginning to thaw. If government overseers had shown greater appreciation and knowledge of the plumbing of the financial system they regulate, some form of Lehman might still be around.

Illustration by: Matt Mahurin

In any case, central bankers and finance ministers frequently act like Pritzker Prize-winning architects charged with trying to unstop clogged plumbing. As a result, they find, as Woody Allen described: “Not only is there no god, but try getting a plumber on weekends.”

In fairness, even experienced professionals struggle to understand the structure of modern markets. One is Jeremy Grantham, chairman of GMO. He recently rated his knowledge of the markets this way: “I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don’t. … It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect [to solve the financial crisis].”

One consequence of the system’s complexity and interconnectedness is that it is difficult to analyze the solvency of financial institutions. The speed with which liquidity and access to funding can evaporate — as with the Dutch bank, Fortis — renders financial statements virtually meaningless.

Agreements governing a firm’s ties to other financial companies also increasingly affect perceptions of its solvency. For example, the downgrade of AIG to below an “AA” credit rating triggered margin calls in excess of $10 billion from the company’s lenders. It also gave AIG’s outside trading parties the right to terminate certain contracts, triggering losses of $4 billion to $5 billion. AIG did not have the resources to meet its obligations — and the government had to step in and bail out the world’s largest insurer.

How a company’s financial distress will affect the overall system can depend on how it is restructured. In the case of Lehman, it was the holding company that filed for bankruptcy protection. The investment bank’s other businesses continued to run. That means financial institutions doing business with Lehman were differently affected by its collapse.

The effects of the demise of Washington Mutual, the largest bank failure in U.S. history, were different. The Federal Deposit Insurance Corp. seized the Seattle thrift following a wave of deposit withdrawals. J.P. Morgan Chase subsequently agreed to acquire WaMu’s banking operations and assume its loan portfolio in a $1.9 billion deal engineered by the government regulator. WaMu’s customers were largely unaffected.

Lehman Bros., New York (Flickr: James Chen)

What’s predictable when financial institutions fail is that investors lose money. With Lehman, unlucky creditors included banks on every continent that had bought Lehman securities and bonds. Because J.P. Morgan did not assume WaMu’s senior unsecured debt, subordinated debt and preferred stock, investors in those financial instruments lost out.

Those losses can be steep. Market estimates of how much Lehman’s debt is worth range from 10 cents to 15 cents on the dollar — a potential loss to investors of 85 percent to 90 percent. In general, recovery rates will be determined by the nature of the assets that Lehman’s counterparties hold — private equity stakes, principal investments, hedge-fund equity, complex slices of risk in structured financial instruments and derivatives. The difficulty in valuing these assets — and the illiquidity of others — may exacerbate investor losses.

One way to examine the complexity of today’s financial plumbing is to focus on a Chapter 11 bankruptcy filing. When a firm files for bankruptcy, all contracts that it has had with trading partners — and the number can be huge — would usually terminate. Lehman reportedly had about 2 million open contracts.

Add to the sheer number of contracts the possibility of incomplete documentation, or plain error. Then throw in operational risks and problems of logistics.

All this triggers a complex chain of events.

The net value of an individual financial contract between a counterparty and a distressed firm may be settled if the contract specifies the amount. If it is the counterparty that owes the amount, it must pay it to the bankruptcy trustee. This means an immediate — and possibly large — cash outlay for the non-defaulting party. If the distressed firm owes the amount, then the counterparty must supply documentary proof to the bankruptcy trustee and await payment.

If the counterparty holds collateral to secure its exposure, then the collateral must be sold to cover the amount due.

If the contract was used as a hedge, its termination exposes the counterparty to its underlying risk. The counterparty must then enter into new contracts to re-hedge itself to avoid additional risk. In general, hedging must be done on a contract-by-contract basis, with limited scope for retrieving net value.

Because this process is complex and time-consuming, the amount of losses sustained may not be certain for some time.

The Chapter 11 filing may also trigger contracts concerning the firm itself. For example, Lehman’s bankruptcy filing would have required settlement of credit default swap contracts that, in effect, insured some of the investment bank’s debt. If a Lehman counterparty held these contracts as hedges, they would ease its losses. In all cases, settlements would create potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehman’s debt, for example, came to about $365 billion.

A firm’s bankruptcy affects other parties through “contagion.” Counterparties that had dealings with the distressed firm either face losses or suffer cash outflows as they meet termination payments. They may face additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality, possibly leading to a fall in their share prices and increases in their borrowing costs. If credit ratings are affected, margin calls may be the result, further threatening solvency.

The overall market is also affected. Greater volatility in asset prices may reflect liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity falls as the number of counterparties drops. Credit becomes scarce, limiting firms’ ability to deal with each other.

Uncertainty over the fallout of a company going under can cause trading in the inter-bank lending market to freeze up. That, in turn, further increases volatility and exposes weaker firms to failure.

Bankruptcy proceedings inevitably accelerate the need to deal with assets that are difficult to value or are illiquid. In resolving the matter, trustees and administrators, acting in the best interest of creditors, can adversely affect the overall market.

And because bankruptcy law is jurisdiction-specific, different sets of trustees and administrators have to grapple with how to best manage the assets of a firm to settle with its creditors. In the case of Lehman, there are already disputes about transfers, totalling $8 billion, made between the investment bank’s London office and those in the United States.

They may also differ in their approaches to dealing with assets. The U.S. trustee in the Lehman bankruptcy indicated that “time was of essence” in dealing with the bank’s assets. In contrast, the British administrator anticipated a long drawn-out affair. All this creates uncertainty about the effect of Lehman’s demise on its creditors and the overall market.

Assets held in a fiduciary capacity can become entangled in this mess. Where Lehman acted as their prime broker, hedge funds and other asset managers face potentially lengthy delays in recovering their investment. About $45 billion in assets, and $20 billion in short positions, are affected. Here’s another problem: Though unable to deal with their assets, legal owners may face margin calls if the value of their positions deteriorates.

A bankruptcy filing can thus reveal the complex networks that tie together all participants in modern financial markets. The chains of risk can spread problems from distressed financial institutions to weak ones, and can ultimately affect even strong firms seemingly remote from the problem.

Assume Bank A, a sound financial institution, has large hedges with Bank B, another sound institution. If a counterparty to Bank B has difficulties, its resulting losses may imperil Bank B, which, in turn, might affect Bank A.

The risk spreads through direct losses, liquidity calls, funding problems or uncertainty. Confidence in the financial system is undermined and financial transactions grind to a halt. It’s a contagion that resembles a hungry wolf pack systematically hunting down the weakest prey in a herd.

Understanding the financial system’s detailed connections, while unglamorous, is the key to anticipating the evolution of a crisis and preventing further exposure to events. It is also where long-term reform efforts should be directed.

John W. Gardner once observed: “The society which scorns excellence in plumbing as a humble activity and tolerates shoddiness in philosophy because it is an exalted activity will have neither good plumbing nor good philosophy: neither its pipes nor its theories will hold water.”

Shoddy monetary philosophies caused the financial crisis. Now inadequate plumbing of the global financial system is greatly increasing its risks.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

flickr (TW Collins)

In “The Arabian Nights,” the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the king, who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.

The worldwide economic drama and tumult are not symptoms of the disease but the cure. The “disease” is the excessive debt and leverage in the financial system — especially in the United States, Britain, Spain and Australia. The “cure” is the reduction of the level of debt — the great “de-leveraging.”

In 1931, Treasury Sec. Andrew Mellon explained this process to President Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. … Enterprising people will pick up the wrecks from less competent people.”

Illustration by: Matt Mahurin

The first phase of this cure is reduction of debt throughout the financial system. So far, overall losses to financial institutions are $400 billion to $600 billion, and that may well go higher. This requires cutting balance sheets — assuming banks are levered around 10 to 1 — of around $4 trillion to $6 trillion in in lending and asset sales.

For example, the bankruptcy of Lehman Bros. meant about $600 billion of debt was eliminated. This inflicted losses on holders of Lehman debt, and that  flows through the chain of capital. The destruction of Lehman Bros.’ capital (around $20 billion) also permanently diminishes the capacity for further credit creation in the future.

The second phase of the cure is the higher cost and lower availability of credit. This forces corporations to sell assets, reduce investment and raise equity — for example, as General Electric has done. It also forces consumers to cut debt by reducing consumption or selling assets.

Reducing investment and consumption lowers economic activity. That puts stress on corporations and individuals that may result defaults that trigger losses in the financial system, which further reduces lending. De-leveraging continues until overall debt levels reach a sustainable level, set by lower asset prices and available cash flows.

This process of destruction echoes W.B. Yeats’ words: “All changed, changed utterly: A terrible beauty is born.”

Within the financial sector, de-leveraging is well advanced. In the real economy, however, it is still in the early stages. Fairy tales in financial markets focus on the “superhuman” abilities of regulators and governments to avoid this de-leveraging.

Central banks and governments,  accepting an increasing range of collateral, have aggressively supplied liquidity to the money markets. Central banks may soon accept items akin to baseball cards — maybe, for example, Lehman, Bear Stearns and Fortis memorabilia, like mugs and tote bags.

Central banks are acting as “buyers of last resort” rather than “lenders of last resort.” They are providing cheap funding. The loans will have to be rolled over, as the banks cannot repay them. They will only be repaid from the underlying cash flows of the assets counted as collateral.

Government and central banks have also “bailed out” a number of financial institutions using a variety of strategies. Lower interest rates and increased government spending have been used to reduce the effects of the financial crisis.

The U.S. government’s $700-billion bailout package is the latest magic potion. It is puzzling why this initiative is seen as the “silver bullet” that can “fix” the problems.

A look at the Troubled Asset Relief Program, or TARP, reveals confusion about what problem it is addressing. The plan to purchase up to $700 billion in “troubled” assets is not dissimilar to existing support provisions. If assets are correctly valued on the books of the banks, then purchase at fair value only provides funding to the bank. The difference is that the risk of the securities is now transferred to the government — but so is any potential recovery in price.

There are different views about how much the government should pay. Under one approach, the government would pay a “hold-to-maturity” price that may be, perhaps significantly, higher than the “market” price, or the value on the bank’s book. This would give the bank liquidity as well as capital.

The alternative approach would be to pay “market” values. This would provide liquidity to the banks but no capital. It could even trigger additional losses where the assets are carried at higher values — creating incentives against participation.

There is also a small problem in that nobody has a  clear idea what these securities are worth.

Purchases of troubled assets are also conditional on (correctly) protecting the taxpayers against losses. This requires banks to provide the government with equity, or equity-like interests, in exchange for participating in the program.

Alternatively, the institutions selling the assets will need contingent arrangements to minimize the risk of loss to the taxpayer. Commentators have gone into rhapsodies about the ability of the taxpayer to “profit” from the program. This creates potential conflicts for financial institutions, whose fiduciary duties require maximization of returns for shareholders.

It is not clear what securities will be eligible for purchase and who will be allowed to participate. Amusingly, the recent short-selling ban on financial institution stocks saw a curious array of companies claim that they were financial institutions! Gaming the system will be practically difficult to control.

In fairness, the final form of the bailout plan is not yet settled and may provide greater clarity. But the bailout could merely transfer the problem onto the U.S. government and taxpayer balance sheet.

Government support for financial institutions in this crisis is already approaching 6 percent of gross domestic product — compared to less than 4 percent in the savings and loan crisis. This could ultimately place increasing pressure on the U.S. sovereign debt rating and undermine Washington’s ability to finance its requirements from foreign creditors.

Government and central bank initiatives to date have been ineffective. Money markets remain dysfunctional and inter-bank lending rates have reached record levels relative to government rates. But the failures are unsurprising.

At the height of the boom, banks used various techniques to increase the velocity of money. Now, as the system de-leverages, the velocity of money has sharply decreased.

Money being supplied to the banks is not being lent through. Banks are parking the money in short-dated government securities, in anticipation of their own funding requirements. Around $2 trillion to $3 trillion of assets are returning to bank balance sheets from the “shadow” banking system that can no longer finance itself.

In addition, banks have large amounts of maturing debt — estimates suggest $1.5 trillion by the end of 2008 — that they must fund. Fear of bank failure, especially after the Lehman bankruptcy, and shortages of capital also limit the banks’ ability  to lend.

Ultimately, nothing can prevent the de-leveraging of the financial system now in progress. At best, actions can smooth the transition and reduce disruption of the economy.

The risk is that well-intentioned steps would prevent the required adjustments from taking place, delay recognition of big problems and discourage action that must be taken by financial institutions, corporations and consumers.

The extent of de-leveraging is substantial and likely to take time. For all asset prices must adjust significantly. The key issues are availability of capital and liquidity. The perceived abundance of liquidity was, in reality, an illusion. As the system de-leverages, it seems clear that available capital is more limited than previously estimated.

Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in U.S. Treasury bonds, GSE paper and AAA rated asset-backed securities. It will be difficult to convert them into the home currencies of investors without large losses.

Government and central bank actions, meanwhile, need to be focused on managing the transition to a lower debt world. Actions should be directed to three areas.

First, banks must be forced to write off bad loans without delay — even if this means breaching minimum solvency capital requirements. Second, bank capital needs must be addressed by forced mergers and restructuring, new equity issues and even nationalization or liquidation. Third, central banks need to guarantee (for a fee) all major bank transactions, enabling normal transactions between banks and other parties in the financial markets to resume.

On Wednesday, Oct. 8, Britain announced a program that addressed some of the above issues. However, coordinated global action is needed so that people do not merely move money from one country to another to take advantage of superior government protection.

A global conference along the lines of Bretton Woods, under a respected chairman — Paul Volcker is the obvious choice –  should be convened. It could bring together all major players — including vital creditor nations, like China, Japan, Russia -– to develop a framework for the major economic reforms in areas like currency policy and fiscal disciplines, to work toward resolving the crisis.

A principal objective could be ensuring supply of funding for the U.S. in the transition period. Recent comments by China about Washington’s responsibility for the crisis and its resolution miss the point. As China’s Premier Wen Jiabao observed the U.S. financial may “affect the whole world.” All creditors have much to lose if the de-leveraging process becomes disorderly.

Like a giant forest fire, the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit  damage to the U.S. economy and the international financial system until the fire burns itself out.

“The Arabian Nights” had a happy ending. The king, after 1,001 night of enchantment and three sons, pardons the beautiful  Scheherazade — who becomes his queen. Despite the fairy tales that investors are now putting their faith in, the de-leveraging at the heart of the current financial crisis may not have such a happy ending.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

U.S. Department of Treasury (U.S. Department of Treasury)

Part 1: U.S. Failing to Defend Dollar

The U.S. national debt is rapidly rising. If Congress signs off on the Bush administration’s $700-billion rescue plan for Wall Street’s troubled financial markets, the debt ceiling will have to be raised to $11.3 trillion. The debt was $9.4 trillion in March. An immediate response to the bailout plan was a falling dollar, which so far has lost half its summer gains in trading this week.

A big chunk of U.S. debt is owned by foreign investors whose currencies’ values are rising relative to the dollar. Already, many have sustained investment losses because of the dollar’s fall in value. With the dollar now losing ground because of the financial crisis on Wall Street, at what point will foreign investors stop buying U.S. Treasuries entirely and throw the country into a debt crisis? Indeed, why hasn’t Washington experienced a sovereign debt crisis before?

The real reason the United States has avoided such a fate is that it finances its debt in dollars. That means Washington can literally print dollars to service and repay its obligations.

America’s special status derives in part from the fact that the dollar is the world’s major reserve and trading currency. The dollar was also once pegged to the gold standard, though that peg, of course, is long gone. But the aura of stability created by the strength of U.S. economic and military power has continued to support the dollar.

But the dollar’s dominance in world markets may be coming to an end. Even when the dollar was rising this year, there was talk of re-denominating trade flows and pricing commodities like oil and agricultural produce in other currencies. Now, with the greenback reversing course, such talk is likely to return.

Illustration by: Matt Mahurin

They is no shortage of signs that the dollar has fallen out of global favor. In the early 1970s, Japanese exports were invoiced almost exclusively in dollars; today only 50 percent are. The Taj Mahal does not accept payment in dollars for its admission fee — only rupees, India’s currency. Some supermodels, even drug dealers, want to be paid in euros, not dollars.

Foreign investors, including central banks, have reduced their dollar-based investments. The percentage of dollars in total world reserves has fallen from a high of 72 percent to around 60 percent. Dollars held outside the U.S. have declined from 1.83 percent of world trade in 2002 to 1.22 percent in 2006.

Foreign investor demand for U.S. Treasury bonds has also softened. Low nominal (negative real) interest rates and the weakness of the dollar are to blame. So is the declining credibility of the Federal Reserve and U.S. Treasury.

For example, foreign investors in Fannie Mae and Freddie Mac debt had long regarded it as “implicitly” backed by the U.S. government. They, as well as more than 60 central banks, hold more than $1,400 billion in debt securities issued by of U.S. agencies, including Fannie Mae and Freddie Mac.

But the travails brought on by the housing meltdown in the United States raised questions about the two mortgage giants’ ability to met their debt obligations. On July 23, the Financial Times reported that the U.S. embassy, after Kuwait’s minister of finance announced that the fund was no longer planning to invest in the agencies’ debt, called the Kuwait Investment Authority, the world’s sixth-largest sovereign wealth fund, to reassure it that bonds issued by Fannie Mae and Freddie Mac were sound. As it turned out, foreign-investor concerns that the mortgage companies would default on their debt in part triggered the U.S. government’s takeover of Freddie and Fannie.

That was in early September. As October nears, Washington needs an estimated $1 trillion to complete its rescue of troubled financial institutions weighed down by toxic mortgages and mortgaged-backed securities. Will foreign investors continue to step up and buy U.S. debt at a time when the creditworthiness of the world’s biggest borrower is under a cloud?

Scrooge’s nightmare, described by Charles Dickens, in which “solid” British assets are changed into “a mere United States security” may become a reality.

At a minimum, Washington will probably have to pay higher interest rates to finance its insatiable borrowing. Ultimately, it may even be forced to finance its debt in a foreign currency. This would expose Washington to currency fluctuations. But, most important, it would not be able to service its debt by printing money. Like all borrowers, Washington would face the discipline of its creditors.

For the moment, however, the dollar is hanging on -– barely. To a degree, this reflects weakness in the euro and yen because of Europe’s and Japan’s economic slowdowns.

The dollar is also a beneficiary of the “too big to fail” syndrome. Foreign investors — especially central banks and sovereign wealth fund investors in East and South Asia, Russia and the Persian Gulf — hold substantial dollar investments that would sustain catastrophic losses if the U.S. were to default on its debt.

The International Monetary Fund estimates that the Gulf Cooperation Council — Saudi Arabia, the United Arab Emirates, Qatar and other Gulf States — could lose $400 billion if they stopped pegging their currencies to the dollar.

So what must the U.S. do?

In 1989, economist John Williamson described a set of economic prescriptions, which he coined as the Washington consensus, that became the “standard” reform package that the International Monetary Fund imposed on countries wracked by economic crisis. The controversial–and highly criticized–package included calls for more fiscal policy discipline; less public spending on subsidies; tax reform; market-determined interest rates; competitive currency exchange rates; trade liberalization; reducing barriers to foreign direct investment; privatization of state enterprises; and deregulation. While many regard this formula as discredited, others still attest to it.

These prescriptions were intended for emerging markets. But, certain aspects of the package could be seen as appropriate for the world’s leading economic power — and premiere borrower.

Some of these elements–fiscal discipline, for example–will be politically difficult to achieve in Congress. Moves to cut farm subsidies face deep-seated opposition. Tax reform seems unattainable. And welcoming more foreign investment is politically dicey. Surveys show that most Americans want U.S. companies to remain in U.S. hands.

But the weak dollar has triggered the “closing down sale” of U.S. assets. On Sept. 29, shareholders of InBev, a Belgian-based brewer, will vote on the company’s $52 million bid for U.S rival Anheuser-Busch, the brewer of Budweiser, the quintessential American beer. Abertis Infraestructuras, a Spanish company teamed with Citigroup, bid $12.8 billion to lease and operate the Pennsylvania Turnpike, America’s oldest major toll road, for the next 75 years. And sovereign wealth funds have provided much of the capital needed to re-capitalise the U.S. financial system buffeted by the housing meltdown. In return, they have acquired major stakes in U.S. companies.

Stephen Schwarzman, head of Blackstone, a private equity firm, put it this way in an opinion piece in the Financial Times in June: “The U.S. is the world’s largest debtor nation and we are now in an uneasy relationship with our creditors. … If we were forced to rely mostly on domestic borrowing, we would have to pay very high interest rates. The consequences would be increased inflation, a dollar falling even faster and very slow [or negative] economic growth. If the investment climate for [sovereign wealth funds]is poor in the U.S., the countries with large dollar reserves (which are the owners of most of the sovereign wealth funds) could … look for alternatives.”

The “adjustment” may be under way. The dry, measured economic prose of the Washington consensus does not capture its human elements. It would require reductions in U.S. real wages and living standards on a scale unfathomable to most Americans.

If you doubt this, just ask the average citizen of any country that has taken the IMF’s “cure.”

Despite its gargantuan appetite for borrowing, there is much to admire about the United States. It remains far wealthier than the new economic titans China and India. It is peerless as a science and technology powerhouse, accounting for 40 percent of total world spending on research and development. Between 1993-2003, America’s growth rate in patents averaged 6.6 percent a year, compared to 5.1 percent for the European Union and 4.1 percent for Japan. America’s economy, with its growing population, secure legal and property rights and well-developed financial markets, remains highly attractive to investors.

But as Warren Buffett 2006 letter to shareholders observed, “Foreigners now earn more on their U.S. investments than we do on our investments abroad … In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest. …. no matter how rich you are, borrowing on top of borrowing is not a great long-term financial plan. I believe that at some point in the future, U.S. workers and voters will find this annual ‘tribute’ (of interest payment on the debt) so onerous that there will be a severe political backlash … How that will play out in markets is impossible to predict– but to expect a ‘soft landing’ seems like wishful thinking.”

And here’s what Economist magazine said: “[P]ublic credit depends on public confidence…The financial crisis in America is really a moral crisis, caused by the series of proofs …that the leading financiers who control banks, trust companies and industrial corporations are often imprudent, and not seldom dishonest. They have mismanaged…funds and used them freely for speculative purposes. Hence the alarm of depositors and a general collapse of credit…”

Those words appeared in the Nov. 2, 1907, issue of the magazine in response to the Panic of 1907, when a crashing stock market led to a run on banks and trust companies.

The U.S. faces a challenge to reestablish its economic credentials. Without drastic and radical action, America’s ability to continue to borrow from foreign investors to finance its escalating debt is likely to become ever more difficult.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article though he may be an owner indirectly as an investor in a fund.

On Oct. 30, 1938, the weekly radio program Mercury Theatre aired “The War of the Worlds.” As adapted from H.G. Welles’ novel and directed by Orson Welles, the effect was stunning. The broadcast’s first half was presented as a series of dramatic news bulletins about a Martian invasion. Many listeners who had missed, or ignored, the opening credits assumed that the invasion was real. Local police were swamped by phone calls from panicky listeners. Some people fled their homes.

The financial equivalent of this broadcast today would be: “We interrupt regular programming to announce that the United States of America has defaulted on its debt!” But, unfortunately, this would be no fantasy news event.

Default means that the borrower has failed to honor his contractual obligations by not paying interest and principal owed to the lender. The most immediate financial effect of default is the loss suffered by the lender.

Yet lenders to the U.S. government have suffered significant financial losses. Not from nonpayment of interest or principal, but because the currency in which the debt is serviced and paid back — the dollar — has lost substantial value relative to other currencies.

Consider a Japanese investor who bought 30-year U.S. Treasury bonds in 1985, when the exchange rate was $1 = 250 yen. Based on the current exchange rate of $1 = 105 yen, the value of the investment has dropped 58 percent. European investors who bought U.S. government bonds in recent years suffered similar financial losses. If they bought U.S. bonds when the exchange rate was 1 euro = $ 0.85, their investment would have lost 46 percent of its value with today’s exchange rate of 1 euro = $1.56.

Such losses to foreign buyers because of the dollar’s declining value are not that unusual. What’s scary for these investors is that these kinds of losses are tantamount to default. Is Washington effectively defaulting on its debt obligations by refusing to defend the dollar? Even today, when the dollar fell around the globe as news of the proposed $700-billion Wall Street bailout spread through the world markets, Washington did nothing.

The U.S. national debt has been rising at a rapid clip. In March, it stood at $9.4 trillion, up 50 percent since 2000. In 2007, it grew by $500 billion, from $8.7 to $9.2 trillion. In 2005, the U.S. national debt amounted to 67 percent of that year’s gross domestic product; in 1988, it had been just 51 percent of GDP. The Office of Management and Budget projects the debt to rise to $12.3 trillion in 2013.

Who owns U.S. debt? Some $2.4 trillion of the $4.7 trillion held privately is owned by foreign investors. Japan holds about $600 billion, or 24 percent; while China’s share is $500 billion, or about 20 percent. Britain, Brazil and the oil-exporting countries own about 6 percent.

Middle East and Russian holdings of U.S. debt may, in fact, be higher. Because these nations might seek to avoid disclosure, Belgium, Caribbean banking centers and Luxembourg — which represent 8 percent — may actually be vehicles for their investments.

What’s troubling is that the $9.4 trillion figure does not take into account the U.S. government’s unfunded liabilities. For example, it does not factor in the huge costs of buttressing Medicare and Social Security as baby boomers retire.

In June, Peter Orszag, director of the Congressional Budget Office, testified before the Senate Finance Committee that, “The U.S. economy faces the long-term threat of ‘collapse’ unless major reforms on health-care spending are instituted in the coming years.” The federal budget, he added, is on an “unsustainable path” because health-care costs are growing faster than the overall economy.

A month later, Richard W. Fisher, head of the Dallas Federal Reserve Bank, said, “The unfunded liabilities from Medicare and Social Security…comes to $99.2 trillion over the infinite horizon.” That works out to $1.3 million per family of four — more than 25 times average household income.

While the national debt is soaring, its maturity is shortening. In December 2000, the average maturity of U.S. government debt held by private investors was 70 months. As of March, it was 53 months. Even more troubling is that, of this debt, 71 percent is due in less than 5 years, 39 percent in less than 1 year.

In part, the shortening maturity of U.S. debt is because the Treasury stopped issuing 30-year bonds during the Clinton administration. This has since been reversed by the Bush administration. But the ostensible rationale was that projected U.S. budget surpluses would allow some government debt to be retired. In reality, low, short-term interest rates during the 1990s reduced the borrowing costs of issuing short-term bonds — which had the effect of boosting annual government surpluses. Today, interest rates are higher, and Washington must now “roll over” significant amounts of debt at those rates in the coming years.

The seriousness of the country’s rising national debt is compounded by the projected 2008 budget deficit of $380 billion — more than 2 percent of GDP; and the current account deficit that is is expected to exceed $700 billion this year — more than 4 percent of GDP.

Combine that with an extremely low U.S. savings rate — which is probably even lower today. Until recently, U.S. consumers counted asset appreciation — primarily their homes and stocks– as savings. The problem was that they borrowed against these assets, now depreciating, to fund consumption.

One mainstay of the U.S. economy had been its vaunted financial system. In 2001, Lawrence Summers, former deputy Treasury secretary in the Clinton administration, extolled the merits of the system at the London Stock Exchange. “The United States is the only country in which you can raise your first $100 million before you buy your first suit.”

Summers dismissed critics who felt that the U.S. financial system’s sophistication in creating new trading instruments was synonymous with financial instability: “[That belief] is observed in inverse proportion to knowledge of these matters.”

In a 1998 speech during the Asian financial crisis, Summers also preached the merits of American-style “transparency and disclosure.” But it is the U.S. that now needs “transparency and disclosure.”

The U.S. financial system has been badly affected by losses on subprime mortgages and the credit crunch. Losses are already in excess of $300 billion. The banking system needs additional capital, despite having raised more than $200 billion so far. The U.S. government has engineered the sale of Bear Stearns to JPMorgan Chase, nationalized Fannie Mae and Freddie Mac, bailed out the insurance giant American International Group and announced a plan to buy bad loans tied to the housing market made by banks. The Federal Reserve has provided almost $500 billion to support the financial system, and the cost of the plan to buy back banks’ bad loans is pegged at $700 billion.

The result of all this is that glabal confidence in U.S. financial markets has greatly suffered. The largely unregulated growth of securitisation and off-balance-sheet vehicles -– the “shadow banking” system -– now threatens the financial system and perplexes many foreign observers. Byzantine U.S. accounting practices — off-balance sheet debt, mark-to-market requirements and derivative accounting — and the failures of the rating agencies, basically a U.S. phenomenon, have also undercut investor confidence here and abroad.

Even the veracity of the economic data released by the government has been questioned. Bill Gross of PIMCO, one of the world’s largest bond investors, and other commentators contend that Washington’s official measure of “inflation” significantly understates actual levels because of statistical adjustments made over the past 25 years. Mohamed El-Erian, co-chief executive of PIMCO, summed it up on June 25: “What has suffered most is the credibility of the most sophisticated financial systems in the world.”

High levels of debt are sustainable, provided the borrower can service and finance it. Washington has had no trouble attracting investors, domestic and foreign, to date.

In recent years, the United States has absorbed roughly 85 percent of total global capital flows — about $500 billion each year — from Asia, Europe, Russia and the Middle East. And risk-adverse foreign investors prefer high-quality debt –- U.S. Treasuries, AAA rated bonds, including asset-backed securities.

Warren Buffett, in his 2006 annual letter to shareholders, noted that Washington can fund its budget and trade deficits because it is still a wealthy country with a relatively strong economy. The problem is that a significant portion of the money flowing in from overseas is not used to finance productive investments. Rather, it funds government spending.

The mass hysteria and panic that followed the broadcast of Orson Welles’ “The War of the Worlds” played on fears about an attack by Germans. It is interesting to speculate whether a broadcast on a U.S. default on its sovereign debt would play on the secret fears of global markets and trigger a similar panic. “We interrupt regular programming to announce that the United States has defaulted on its debt!”

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article though he may be an owner indirectly as an investor in a fund.