Following on from their generous bail out of Northern Rock, the UK Government, otherwise know as the taxpayer, has opened its arms to any old piece of paper banks have sitting around on their balance sheet.

Or to be more accurate, the Bank of England will accept mortgage backed securities in return for government bonds. Nice trade if you cant get it. The amounts mentioned are 50 to 200bln pounds (where the hell is my pound key?) but basically it’s a free for all.

Now we can expect to see banks reaching for the refinancing button in order to take advantage of this. RBS has already put its hand up for 10 to 12bln of fresh capital plus a 6bln write down.

Ok so its just more mess. The markets may rally on this hoping it can help clear the looming crisis in the mortgage market but the numbers are really starting to mount up and this is just very bad news indeed.

The key issue here is the capital adequacy of the banking system. It’s proven to be the achilles heel which is why the authorities have had no option but to underwrite the system.

Given this exposure of the fragility of the banking system it is time to ask questions about capital adequacy and the way banks are regulated and allowed to operate.

The G7 communique from the current meeting makes for interesting reading. Their focus has been wide ranging and, for a change, not just on currencies though the headline statement does make a clear reference to recent moves.

What I took note of was their concerns around bank capital. This is really where the crunch point is located. They call for the Basel Committee to review liquidity risk management guidelines and a quick disclosure of write downs ands revaluations (or in reality devaluations).

The accounting for off balance sheet items was also raised, particularly the valuation of assets in a time of financial stress. That should cause palpitations amongst traders of credit default swaps. Quite frankly some of this stuff can only be valued when its traded. The idea that there is some kind of two way market is really a myth. That in itself should make regulators, as well as bank shareholders, sit up and think about some of the toxic trades sitting around on the books.

They also call for a speedy implementation of Basel II. I think they should tear up Basel II and move straight onto Basel III but more on that another time.

They realise the game is up and the time has come for a thorough overhaul of the system itself. It will be interesting to see how this plays out as more and more unwinding takes place. As far as currencies go, China was gently reminded to hurry up and revalue the Yuan and the market was reminded that G7 wasn’t happy about some of the moves we had in March.  Whether that helps the $ is anyone’s guess but they better have an intervention plan up their sleeves before the $ takes another big dump.

The markets had a nice rally but reality is never too far away in markets and the last couple of weeks may have just been a pause for thought.

Bear Stearns finally ran up the white flag today and was forced to seek funds from JP Morgan for 28 days. These loans have been underwritten by the Fed essentially preventing Bear Stearns going under.

This was the moment of truth for the Fed. They blinked.

Now they have underwritten the US banking system they will have no choice but to support any institution that experiences similar problems. On one hand this is a prudent move as the implications of a bank failure are very serious but the sad fact is that in order for the market to recover from this era of cheap and funny money is to allow failure to occur.

So the taxpayer can now expect to pick up the tab for this party. It will be interesting to see if this spreads outwards from the US as the credit markets simply disintegrate.

Expect more official action next week probably involving currencies as well.

With rumours continuing to circle around main street financial institutions in trouble, the Fed along with other central banks piled in another $200bln worth of liquidity in a vain hope to stem the tide. It certainly worked sparking a massive rally in the US market which was looking very weak indeed.

I wrote 6 weeks ago that the Fed would have no option other than to underwrite the whole financial system. This is exactly what they are doing. The worrying aspect of this approach is that it leads the market to depend on continuing liquidity to provide confidence and prevent what would be happening without intervention, namely a full scale rout with several institutions going under.

This creates extreme moral hazard. Even though many financial institutions have clearly acted irresponsibly and in some cases in other ways, they will not be allowed to fail unless a “deal” is worked out where they will be “acquired” quietly for a nominal sum and so the system stays solidly in place and the illusion is maintained.

F.William Engdahl lays out his thoughts on the origins of this mess. It’s focus is the US over the last 100 years and is interesting to read though he makes some strong accusations about the actions of certain people.  The extent to which small cliques have organised and run the financial system is open to questions but there is no doubt that the US prevailed at Bretton Woods on the strength of pure self-interest.

So what now? Well I would say more of the same. But gravity is a powerful force and its hard to imagine these markets not falling further and more de-leveraging taking place in credit and carry trades. I’ll discuss shortly what a new global currency system might look like because the current one is about to explode.

Well Christmas brought some quiet stability to the markets but the New Year has seen an immediate stampede for the exit. What is so interesting about the current economic malaise is that it’s very hard to analyze with any clarity. No one really knows what is going to happen because we’ve never had a crisis of this magnitude before.

We know the credit bubble has well and truly burst. We’ve seen it before with Japan but that was really a closed market and the response was non existent thus causing a 15 year depression. We have Central Banks who are very keen and swift to act but will their actions just make things worse. Henry Paulson today said a correction was inevitable given the price increases of the last 5 years.

Nice to know the guys running the country are on top of things….crickey! Can anyone explain what a stable economic system looks like. Clearly the current bunch of economic leaders haven’t got a clue.

Ambrose Evans-Pritchard argues that we are experiencing a 1929 type situation. I think he is spot on. The bailouts we’ve seen recently could well become more widespread. If that happens then quite clearly the stock markets will fall another 10%. The impact on BRIC (Brazil, Russia, India, China) will decide whether the global financial system collapses or not.

Immediate rate cuts will be forthcoming from the Fed, BOE and maybe even the ECB. All this nonsense about watching inflation needs to be ignored. Inflation will keep being a problem but its a diversion. 2 years out and land prices could be off by 30% or more.

Investing now is for the brave hearted, foolish and very wealthy following the maxim “The way to make a small fortune is to start with a large one”.

As the Fed prepares for another rate cut, probably 25bps, possibly 50, markets are resilient in the face of what is still a horrendous credit meltdown. With Merrill Lynch reporting a monumental loss last week, it is clear that banks are still clearing away the debris of the last few months and the real impact may not be felt for some time.

Never mind the jokes (you can’t bail out anything with a siv)around the Super SIVs: the great $100bln bailout plan hatched by some genius to support the market. Similar to the rescue plan post LTCM crash, it basically involved the market coming in to buy its own distressed assets. Liquidity is the mantra but holding up the market is the reality.

Everything is under water so its a game of smoke and mirrors. As I’ve said before its a rational response to a difficult situation. The social impact of a complete financial crash is not something anyone wants to see but the longer we put off the necessary surgery the worse it will be.

The credit bubble of the last 15 years is over. The balloon has too many holes in it and its a waste of time pumping more air into it.  Satayjit Das, author of Traders, Guns and Money lays it all out in this paper. Its worth a read.