Why is the credit crunch back?

The fifth-biggest bank in the US gave warning yesterday that it might not survive, admitting that it is being bailed out by one of its rivals and the US Federal Reserve. The implosion of Bear Stearns is America’s version of Northern Rock — but as one is essentially a provincial British bank and the other a titan of global capitalism, the ripple effects of Bear Stearns’s woes are likely to be far wider-reaching.

I’m still struggling to care. This is a US problem, right?

This should be of deep concern for anyone in Britain with a mortgage, a loan or even a job. The credit crunch has increased to a new level of fear among market watchers.

The failure of Bear Stearns, which takes its name from two of its three founders, Joseph Bear and Robert Stearns, is frightening for two reasons. The bank may survive this crisis with the help of the emergency funding, but it could still fail — leaving all the investors and banks that have relationships with it hugely out of pocket. This is worrying enough, but it is the nature of Bear Stearns’s plight that causes much of the concern. The immediate crisis at the bank stems from investments linked to the good-quality mortgages that we all thought were safe. The fact that they are not is frightening.

Why has the safe suddenly become risky?

The credit crunch started with the collapse of sub-prime mortgages. Poor American families were sold toxic mortgages. Chunks of these mortgages were packaged up and sold on to banks, pension funds and other investors. It became increasingly obvious that these sub-prime mortgages were not that safe and all the bonds — or debt — that used sub-prime mortgages as collateral began to unravel.

Imagine that you borrowed £500,000 using as collateral a house that turned out to be worth £5,000. The bank wants its money back but you’ve only got a cheap house that nobody wants to back up the loan.

But the problem just got worse. There is also a huge market in financial instruments backed by good-quality mortgages. Last year alone about $366 billion (£180 billion) of bonds backed by mortgages of all kinds were issued by global banks. Ten years ago $16 billion was issued. This market is too huge to fall over with no repercussions.

Why are good-quality home loans a worry?

When the sub-prime markets collapsed, banks stopped lending to each other. An atmosphere of fear and mistrust now rules the financial world. The good-quality mortgages backing billions of dollars of loans, held by a range of companies, are increasingly seen as vulnerable. Once rumours start about how safe an asset is, it is difficult to know how much it is worth.

Everyone wants their money back and invested in areas they know to be safe. This is one reason why gold pushed past $1,000 (£495) an ounce for the first time in history this week.

Imagine that you borrowed £500,000 from the bank on a house valued at £475,000. Suddenly, the housing market goes mad and nobody can tell you how much the house is worth: it could be £350,000 or £300,000. The bank wants its money back but nobody wants to buy the house or knows its worth.

Is this the beast we’ve been waiting for?

Over the past week fear and rumour have led to intense speculation that a leading bank was in trouble — the beast hiding under the markets’ bed. The unprecedented co-ordinated action by the Federal Reserve and other key central banks to pump $280 billion of liquidity into financial markets on Tuesday, which followed hot on a separate Fed injection of $200 billion a week earlier, caused consternation. Did the central bankers know something we didn’t?

Attention turned to Bear Stearns. The market believed that the bank was sinking but management insisted the markets were wrong. Yesterday the markets were proved right.

Are British banks in trouble?

Not on the same scale. But most banks with a global reach hold investments backed by mortgages. The hit to the world’s banks on investments backed by sub-prime mortgages alone has reached almost $200 billion. Now that the crisis has spread to better-quality mortgages, more multibillion-dollar hits to all banks’ profits look likely.

Is the problem just with the banks?

No. We have seen a spate of collapsing hedge funds. More are expected. Hedge funds, once upon a time, were aptly named, denoting funds with strategies designed to limit losses on the stock market. Nowadays, they are a motley collection of funds with varying degrees of risk that have a few things in common: aiming to make money in all market conditions, the ability to bet on shares falling as well as rising and very well paid managers. Hedge funds are also often in debt to the big investment banks. When these banks are in trouble, they want their money back, leaving heavily indebted hedge funds exposed.

Anyone else to worry about?

Yes. Sorry, the pain is not over yet. Private equity companies are also looking suspect. In the years running up to the credit crunch, these private equity firms spent billions of dollars buying up public companies. They funded the deals with massive amounts of cheap loans. The fear is that the banks will now want their money back, leaving private equity companies in deep trouble.

Why is this different from any previous global financial crisis?

The world’s financial companies are all more linked than they have been at any time in history. Imagine a giant spider web, with the US banks at the centre and everyone from investment funds in Japan to hedge funds in Paris linked through a complex of loans and fiendishly complicated financial instruments. The substance of this web — the fine lines connecting all the institutions — is cheap debt.

The problem now is that the cheap debt has dried up and the web is crumbling. As each institution falls, whether it is the British hedge fund Peloton, which collapsed earlier this month, or the Amsterdam-based CCC, or Bear Stearns, the fall of a financial house snaps myriad other links in the web. Some breaks are obvious but others take time to uncover. The fear is as corrosive to the web as the actual act of an institution falling.

But what about me?

You might not know this, but you, too, are part of this web. The most obvious, immediate effect of all this crisis is that it will have a profound effect on your relationship with your bank. Cheap mortgages and loans have already disappeared. Just as the close relationships between the world’s financiers have been fuelled by cheap credit, so has the consumer boom in Britain.

We are sitting on a £1 trillion debt mountain in Britain. Debt stands at 175 per cent of household income.

Just as CCC faced a cash crisis when its donor banks pulled the plug, so will indebted Britons find themselves struggling when they attempt to remortgage or refinance their overburdened credit card.

I live within my means. Surely I’ll be OK?

At the moment, the world faces a huge financial crisis. The fear is that it will spread to become a huge economic crisis. The US is arguably already mired in a recession triggered by the credit crunch. The dollar is crumbling. The question is how deep and how prolonged this downturn will be. A few more seismic shocks, such as the implosion of Bear Stearns, and this crisis could be the worst for a generation. Where the US goes, we tend to follow.