All this craziness requires a creative escape route

But fear of the unknown is also generating indiscriminate and potentially damaging reactions. We saw it in this market yesterday when Macquarie Group's shares plunged by 23 per cent, and on Wall Street before local trade, as shares in the last two independent investment banks, Morgan Stanley and Goldman Sachs, were hammered.

All three groups have been pressured by the crisis, but there is nothing obvious on their balance sheets to warrant the treatment they have received.

Fear also surfaced yesterday in the virtual freezing up of the futures market for US dollars. US dollar forward trades became progressively tighter as the week progressed, and locked up for the first time in Europe on Wednesday night. They began to flow again when the US market opened, but re-froze after trading moved out of the US and into our region yesterday.

The benchmark US cash rate is 2 per cent, but in markets including Japan and Australia yesterday US dollar overnight cash was being quoted at 11 per cent and 12 per cent, and even then, buyers were basically unable to get trades done.

The practical effect of the freeze is that hedges against movements in the US dollar become impossible.

The more important psychological effect is that it signals that counterparties are closing their doors to each other - even at the cost of creating a liquidity crisis in the currency that is central to global market operations.

Each bank can justify its action, of course. The gold price may have posted its biggest jump in 26 years yesterday as investors fled to a metal that has always been seen as a bolt-hole in times of crisis, but banks can also rationalise holding back US dollars - because the greenback is the default currency for storing cash, another safe-haven, and because Wall Street's meltdown notwithstanding, the US dollar is still desirable, as the rush into US short-term government bills that this week drove yields to lows last seen in World War II demonstrates.

The vast bulk of dodgy financial instruments caught by this crisis are also US dollar denominated. They underpin real assets, and US dollars would be freed up if they were sold. But asset sales had slowed to a crawl even before the purge began this week, as sellers baulked at booking big losses, and have now stopped entirely.

Last night the world's central banks were moving to unlock the currency market with a massive $US180 billion liquidity injection. That can't hurt, and might well help - but more and different intervention will be needed before the fear accompanying this purge recedes.

As Goldman Sachs JBWere noted yesterday, the purge has already cleaned out the obvious suspects in the US market.

Of a dozen groups rated relatively highly by GSJBW for financial risk in mid-2007, five were American. Two of them, Bear Stearns and Merrill Lynch, have been taken over by less aggressively leveraged banks (JPMorgan Chase in Bear's case, and Bank of America in Merrill's, at the beginning of this week).

Another, Lehman Brothers, filed for bankruptcy on Monday, and has since sold its investment banking business to Barclays of Britain for next to nothing. A fourth, Freddie Mac, has been nationalised by the US government, along with its mortgage financing big sister, Fannie Mae.

The fifth US group on Goldman's list of 12 was Morgan Stanley, which was reported to be considering a bank merger, possibly with Wachovia of the US, after its share price mauling on Wednesday night.

The logical next focus of the Purge That Refreshes is Europe. Until yesterday's shotgun marriage of HBOS and Lloyds, there had been only one notable purge outcome in Euroland - the British Government's nationalisation of Northern Rock, which was hit early in the crisis by a depositor run.

But fear is driving the market, not logic, and it is producing less discriminating pressure. Macquarie's 23 per cent share price dive yesterday, for example, belies the group's solid capital ratio, $25 billion of deposits, and the fact that Macquarie is a licensed bank, with the regulatory safety net that implies. And third-quarter profit reports from Goldman and Morgan Stanley this week also revealed rising balance sheet strength rather than the reverse.

Rumours that investors were withdrawing funds from Macquarie were categorically rejected by official sources yesterday, and in the case of Macquarie and the two US groups, the sharemarket maulings were much more closely correlated to rising credit default insurance quotes on them than anything else.

The only thing that has pushed credit default swap premiums on the three groups higher this week is fear of the unknown, however: shares and credit default swaps are, in other words, sustaining a fact-free valuation vortex as the purge expands, and that's a very dangerous nexus.

UBS issued a report yesterday describing the sharemarket descents of Morgan Stanley and Goldman as madness - but there's nobody yet offering up concrete ideas about how the toxic nexus between credit default spreads and the sharemarket can be broken.

Adding liquidity is part of a longer term solution that in the end must reassure investors that what they see in the balance sheets of groups like Macquarie, Goldman and Morgan Stanley is what they get.

The proactive and faster solution would be to cauterise the market bleeding by locating a merger partner: Morgan Stanley at least is already considering its options for a deal that it can negotiate from a position of strength.