As stock markets tumbled around the world yesterday, bankers reached for the wisdom of David Brent: “If you can keep your head when all around you have lost theirs, then you probably haven’t understood the seriousness of the situation.”

The situation is, undoubtedly, serious. Every stock in the FTSE 100 fell yesterday, as the index suffered its biggest one-day decline in four years. The UK market is now off just over 13 per cent since its peak in June. This is not a 1987-style stock market crash, but it is a significant correction: more than £120 billion has been wiped off the value of the market in a week.

Hank Paulson, the US Treasury Secretary, gave warning yesterday that the financial turmoil will take its toll of economic growth and that “some entities will cease to exist.” Investors behaved as they do on the eve of a war, scrambling for the safety of short-term government bonds: the yield on three-month US Treasury bills fell further than it has on any day since the 1987 crash. The implication is that financial institutions are calculating that things are going to get a little worse before they get better.

The financial markets have prospered in the past few years, because institutions have borrowed unprecedented sums of money to fund their investments. This boom in “leverage” has been possible because the financial world has been engaged in two global games at the same time: pass-the-parcel and spot-the-difference – otherwise known as Collateralised Debt Obligations and the yen carry trade.

The CDO, until recently an arcane acronym, is just one example of the burgeoning business of securitising debts. Banks have developed financial instruments – the CDO is just one of them – so that they can repackage loans and sell them on to other investors. Because they are, in effect, passing off parcels of debt, they have less on their own balance sheets and are willing to shoulder greater levels of lending.

The yen carry trade has, for years, seemed like a no-brainer, which has involved borrowing cheap in Japan to fund higher returns elsewhere. Interest rates in Tokyo have been near zero, so financial investors around the world have borrowed money in yen to buy equities, bonds and currencies that offer even marginally better rewards.

But both of these games have recently shuddered to a halt. The collapse of the US sub-prime mortgage market has had a devastating impact on the broader credit markets. It has revealed that debts bundled together in such a way that they were sold to investors as top quality triple-A paper were, in fact, very risky loans. This has spooked investors everywhere. If they cannot differentiate between a safe bet and a dangerous one, they would rather not bet at all. In countless ways, the sudden closing of the private debt securities markets, valued at $27.6 trillion, has had a knock-on effect on the equity markets, valued at $23 trillion.

In turn, this has had a damaging effect on hedge funds. As they have incurred losses, their investors, fearful of losing more, are asking to redeem their funds, ie, demanding the rest of their money back. This, it seems, is forcing some of the hedge funds to revisit their yen borrowings. And this may not sound like much, but it could signal the end of investment life as we know it.

The signs yesterday were that large parts of the yen carry trade are unwinding. Prolonged spells of low interest rates generally mean that risk will be mispriced somewhere in the system. Japan’s extraordinary decade of near-zero rates may have unwittingly allowed a supremely dangerous anomaly to develop: a spectacular, long-term global accumulation of mispriced risk.

The great trouble is that the ball of string currently unwinding is invisible: nobody anywhere – especially not the Bank of Japan – has any true sense of how far it all goes. We know that yen carry has financed US, European and Asian hedge-fund investment in risk assets, but how far has its use permeated every market? Much the same is true of the syndicated debt market: who has been left holding the baby?

Comparisons are easily made between this anxious August 2007, and the flight to safety in 1998, when Long Term Capital Management collapsed and Russia defaulted. But the difference this time is that it is harder to know who is to blame: the ratings agencies for failing to price debt accurately because they were in the pocket of the banks? The central banks for steadily pushing up interest rates, because they were worried about excesses in the credit markets? Commercial banks, which stopped pricing risk, because they could not afford to miss out on the mushrooming debt business?

The global economy remains strong and corporate performance robust, but there are uncertainties at the heart of the financial system. The underlying dangers are probably not as bad as many people fear. The problem is not knowing what they are. What is troubling the markets is, perhaps, best captured by that other hapless former office manager, Donald Rumsfeld: “As we know, there are known knowns . . . But there are also unknown unknowns – the ones we don’t know we don’t know.”

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