Mutually Assured Destruction

We are faced with the total and complete annihilation of modern capitalism as we know it. With Lehman bankrupt and hence it's debt gone to junk status, AIG facing ratings downgrades and WaMu down to junk, here's whats going to happen as the dominoes fall one by one:

1. Lets say that I am financial institution. My balance sheet is probably a couple of hundred billion dollars, but the equity position (i.e. assets less liabilities) is quite possibly in the tens of billions of dollars i.e. at the minimum a 10 to 1 leverage. Lets assume that I have been conservative with my investments and most of my Assets are AAA (the highest investment grade) rated. So I don't have to carry that much Cash because the value of these investments should cover my liabilities.

2. Therefore as and when these investments receive a ratings downgrade I must increase the level of cash that I carry, so that I can cover the loss in value of the erstwhile AAA investments. If I can't raise cash then my own ratings get downgraded.

3. That in itself is not so bad except....everything and everyone else (i.e. other financial institutions) is leveraged and at equilibrium. So if I can't raise cash not only do I get downgraded but anyone else holding investments issued by me is affected and they have to raise capital to cover the loss in values of paper that I have issued or contend with having their rating lowered.

4. Well that's still not fatal in itself .... except much of the investments that I have made and others have made based on paper I have issued are made up of derivatives which are not regulated and are of indeterminate value. Or to be precise whose value can be determined only by a bunch of PhD(s) and a gaggle of lawyers.

5. Now all these investments are interconnected and held by State funds, mutual funds, world funds , sovereign funds and god knows what else then the entire world's markets melt down together because no one knows what the true values of any investment are and therefore no one can be trusted to make good on any liability.

Default thus turns to liquidation... KABOOM!

For the record I am short the US Financial Sector, Short Crude and Natgas, Short Small Cap and Short Basic Materials.