It has been a torrid six weeks, but how will things play out over the next few weeks and months?

As the screenwriter William Goldman said about Hollywood’s inability to predict which films would succeed and which would be turkeys: “Nobody knows anything.” That could be the motto of the financial markets as they peer anxiously into the future. It is the complexity and opacity of trillions of dollars of debt securities and allied derivatives and the resultant uncertainty that have so spooked traders. It may be that the fears are overdone and that we return to normality. Certainly, the mood music from the share and bond markets has been less sombre in the past week and share prices actually have been hardening in recent days.

So what is the optimistic scenario?

Debt traders and investors come to view the summer lurch from greed to fear as overdone. Yes, some debtors will default, some loans will not be repaid, but most balance sheets are easily resilient enough to withstand the pain. Central bankers have made it plain that they are prepared to intervene to supply struggling institutions with short-term injections of cash. They also seem prepared to cut interest rates, again easing the strain and improving sentiment.

But how does that square with the talk of financial Armageddon of only a few weeks ago? Surely, there has to be more of a reckoning?

The optimistic view is that the financial system is stronger than in the past because risk really is much better spread. Derivatives, it is argued, really do work in dispersing risk. Hedge funds, it is argued, really do dampen violent market swings by taking the contrarian view and buying when others are selling and vice versa. And central bankers, it is argued, really are better atuned to financial markets and the need to act to maintain stability.

Do these arguments hold water?

Not entirely. It is true that derivatives have dispersed risk worldwide, but there still are huge concentrations of exposure. Bank of China revealed on Friday that it had exposure of $10 billion (£5 billion) to US sub-prime mortgages – home loans to borrowers with poor credit histories that have been at the heart of the financial crisis. Some hedge funds, far from taking bold contrarian positions, have, in fact, been engaging in herd-like behaviour, especially quantitative, or “black box”, funds, whose decisions are dictated by computer programs. In general, however, markets in the past ten years have handled shocks better than in the past.

Any other reasons for optimism?

Yes. Institutions are starting to see the battered financial landscape as throwing up opportunities as well as threats and are risking hard cash in backing that view. Last week Bank of America ploughed $2 billion into support for Countrywide Finanical, America’s biggest mortgage provider, buying preference shares in the business. Goldman Sachs decided with various external partners to rescue its hedge fund Global Equity Opportunities with a $3 billion cash injection rather than let it go to the wall. HBOS has started to put its own capital into Grampian, a giant credit arbitrage fund, rather than let it be buffeted by the gyrations in the short-term debt market. These moves can be interpreted as defensive efforts, but they also suggest that some of the heavy hitters are reasonably confident that stability will return sooner rather than later. For now, panic has abated.

What is the middling scenario?

This is that a steady drip of negative news will continue to sour sentiment at least for the next six months. While markets will stabilise, investors will be in no hurry to place fresh money with any but the safest and simplest of homes. More generally, risk will be more realistically priced and the high levels of leverage of the past couple of years will not be tolerated.

There is a vast backlog of loans agreed or promised that are waiting to be syndicated. That will certainly clog up bank balance sheets for months, if not years. That, in turn, will tie up capital and prevent banks from doing other business. Debt is going to get pricier and, in some cases, rationed.

Rumour and speculation continue to plague numerous financial institutions. Last week Standard Chartered was under the cosh because of worries about its exposure to US sub-prime through a special-purpose vehicle.

Surely there is more certainty than this? Aren’t these investments rated by credit agencies?

Yes, but there have been serious questions raised about the accuracy and timeliness of ratings by agencies such as Standard & Poor’s and Moody’s. Institutional investors that try to placate markets with the claim “but it’s triple-A rated” are more likely to be greeted with howls of derision than grateful relief.

But don’t financial institutions have to report their best estimates of any losses to shareholders at once?

Not always and not immediately. Listed banks and other institutions are obliged to alert the stock market only if there is a “material” change in their profit prospects. Material is generally interpreted as a change of 10 per cent or more. For a bank such as Barclays, for example, which made £7.1 billion before tax last year, it could, in theory, sustain losses of up to £700 million and not feel obliged to inform shareholders immediately. And there are other complications. First, billions of dollars of asset-baced securities and derivatives are hard to value. They are thinly traded and banks use computer models to value them. The assumptions on which these models are based may prove to be overoptimistic. When thousands of end-of-year bonuses depend on the losses being as small as possible, banks may not be realistic. The other problem is that the securities are held off balance sheet in tax havens.

Off balance sheet? Now you’re getting me really worried. Isn’t that what Enron did?

Yes, although these vast bank-controlled vehicles, known as “conduits”, or credit arbitrage funds, are regarded as legitimate means of matching institutions with cash to park with borrowers with the appetite to borrow. However, losses in these conduits might not have to be reported immediately even though the sponsoring bank would probably ultimately have to pick up the tab.

For all these reasons, then, there could be long delays before losses are crystallised and reported. The drip of bad news could be prolonged. According to William Goss, managing director of the bond investor Pimco: “Defaulting exposure can hibernate for many months before its true value is revealed.”

And the doomsday scenario? Just how bad could things get?

A lot worse. There are two main threats. One is the risk of financial contagion – the possibility that the failure of one institution could lead to the toppling of others. A cat’s cradle of derivative contracts links the world’s financial institutions.

Central banks and regulators appear alert to the danger. The Federal Reserve Bank of New York successfully orchestrated a rescue of the collapsed hedge fund Long Term Capital Management in 1998, when a systemic collapse was most recently feared. But there is always the possibility that a catastrophic collapse happens too quickly or that private sector banks refuse to cooperate in a bailout.

The other big risk is that the downturn in the US housing market proves longer and deeper than forecast. Americans are already facing the biggest reduction in their wealth levels since the Great Depression. That is if house prices fall by only 10 per cent.

Clearly, larger falls could both worsen losses in sub-prime and ordinary mortgages and feed through into the real economy with people spending less because they feel poorer. Yesterday the Centre for Economics and Business Research downgraded its forecast for world economic growth from 3.8 per cent to 3.4 per cent, citing the weakness in the US economy.

So what is the most likely outcome?

Somewhere in the middling scenario looks most probable, but we are in unknown territory. Never in capitalist history has so much debt been taken on by so many people. Never have the securities backed by that debt been shaped, stretched, packaged and hedged in such complex, opaque ways. Hollywood is a model of simplicity and transparency compared with the global money markets: nobody knows anything.

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