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Banks vulnerable as 'rotten' foundations crumble

  • Story Highlights
  • World's investment banks are basically houses built on pillars of money
  • The rot has got into the pillars and no one noticed
  • Every event puts these pillars under more strain until they crumble
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From CNN's Richard Quest
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(CNN) -- From pubs in London to bars in New York, everyone is asking the same question: Why is this financial crisis different? The answer is simple albeit not sexy. The rot has set in.

The world's investment banks are basically houses built on pillars of money. Sometimes those pillars are cash, often bonds; these days pillars are made up of derivatives, swaps, options and other frighteningly complex instruments.

But these pillars are the strength that supports not only the bank itself, but also its debts and liabilities. Under technical rules the pillars have to be transparent and of a certain quality, so that investors know just how well propped up the bank is. In layman's terms -- everyone can tell "the bank is safe!" If the pillars remain strong -- the bank stays standing.

What has happened is that the rot has got into the pillars and no one noticed. If they were wooden it would be worms. The very financial instruments that make up the core of the banks are questionable.

No one can say for certain how much these instruments are worth, if anything. No one knows if counterparties to deals are financially secure and will be around tomorrow. The very structure upon which banks like Lehman depended became doubtful.

If this was happening to just one or two banks then it would be a "nasty business." But it is happening to all the banks -- at once. The major names have all been taking on these dodgy instruments and are all now seeking better quality investments and cash. And of course those with the cash want to keep it to themselves, in case they need it -- hence the term credit crunch.

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Often during a period of financial turmoil there are clearly definable events -- oil crises, war, acts of terror -- which cause a loss of confidence which leads to a slowdown and possibly a recession.

But the infrastructure of the banks remains by-and-large solid. The pillars remain standing. Here the exact opposite is happening. Every event merely puts dodgy pillars under more strain and eventually they give way.

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This is what links today's crises with those of the past: 1929 Wall Street Crash; 1970's Oil Crises; Black Monday, 1987; the Dot Com bubble bursting in 1998. In all cases it wasn't just a turn of the economic cycle gone wrong, it was a problem at the very core of the financial system which in size and scale meant everyone was affected and from which no one escaped.

How will this play out? Badly. Until the financial pillars can be rebuilt then there is little anyone can do but watch some banks get rescued, while others collapse completely.

All About Lehman Brothers Inc.

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