The Financial Crash In Plain English

Credit crunch. Northern Rock. Bear Stearns. Fannie and Freddie. Lehman Brothers. AIG. HBOS. Here's what the financial crash means to you.

Following years of feverish expansion, the financial system is having a fit. Low interest rates and cheap credit fuelled big gains in house prices and other assets. This created an environment in which banks were eager to take on more risk. Hence, they lent ever-more money to ever-more people in a race to the bottom of the barrel. Eventually, banks ran out of good customers to lend to, and started doling out money to people with poor credit records who had little hope of repaying their debts.

Bank then rolled up these risky loans (`subprime mortgages') into mortgage-backed bonds (IOUs). Using financial alchemy, bankers waved a magic wand and turned these bonds into highly rated securities. These were sold to banks, insurers and pension funds around the world. Thus, what could have been a local problem has escalated into a global drama.

How did it all go wrong?

As US house prices started to fall in 2006, the value of bonds backed by subprime mortgages started to slide. Very quickly, investors realised that they had been mugged, causing the market for mortgage-backed securities to grind to a halt. This prevented banks from parcelling up and selling on loans, thus restricting their ability to continue lending.

As banks grew anxious about each other's exposure to these toxic loans, they became increasingly wary of lending to each other. Thus, inter-bank lending (`wholesale lending') dried up in early August 2007. Within a month, this `credit crunch' had claimed its first scalp in the UK - Northern Rock.

The next victims

Although clever banks had sold on much of their subprime lending, many kept the supposedly choicest cuts for themselves. Then as house prices slid, the loans turned nasty and the US banks started to lose tens of billions of dollars.

Then in March, Bear Stearns, was rescued by JPMorgan Chase with government backing. The biggest bailout in history arrived at the start of this month, when the US nationalised the two biggest players in the American mortgage market, Fannie Mae and Freddie Mac.

A week later, Lehman Brothers, America's fourth-largest investment bank, collapsed into bankruptcy. This forced number-three player Merrill Lynch into the arms of Bank of America. Next up was AIG, the world's largest insurer, which received an $85-billion bailout in return for giving the US government an 80% stake in the firm. This week, the UK's biggest mortgage lender, HBOS, is being taken over by rival Lloyds TSB.

What does this mean for you?

The bad news is that very few people will be entirely immune from this financial meltdown. Thanks to these poisonous loans, banks worldwide have already lost over £250 billion. Even worse, this loss could double or quadruple before things improve. Hence, in order to rebuild their capital and profits, banks must increase lending costs.

Therefore, thanks to interest-rate hikes, borrowers are being hit hard. We've already seen rates climb for mortgages, personal loans, overdrafts and credit cards. Nevertheless, as the economy slows down, rising bad debts will take their toll, forcing lenders into further rounds of rate rises.

Likewise, homeowners and property investors are suffering a double whammy, thanks to falling house prices, higher mortgage rates and a steep fall in the availability of home loans. Personally, I welcome lower house prices, as should anyone with plans to reach higher up the property ladder. My view is that the current property weakness will continue into the next decade, with no recovery before 2010.

In addition, stock-market investors around the world have suffered as economies begin to slow, company profits slip and share prices dive. Indeed, the failure of some massive companies has spooked investors, with the blue-chip FTSE 100 index falling below 5,000 this week -- a level not seen in three years. Although the UK stock market looks cheap on certain measures, I wouldn't call the bottom just yet.

On the other hand, savers are doing very nicely, as a result of the banks' desperate dash to stash more cash. Interest rates on Best Buy savings accounts have hit levels not seen since 2001. In fact, this craving for cash means that sensible savers can earn fixed rates in excess of 7%. Given that three-quarters (75%) of all Britain's wealth is owned by the over-55s, well-heeled pensioners will benefit from higher savings rates.

Alas, rising inflation (higher prices) is undermining the value of the pound in our pocket. Last month, the Consumer Prices Index (CPI) measure of inflation hit 4.7%, its highest level since becoming the official measure of living costs. In other words, keen spenders will find retail therapy much less affordable, thanks to falling disposable incomes.

Finally, falling company profits and the economic slowdown will lead to lower tax revenues. With public spending rising relentlessly, the government will have to milk taxpayers harder in order to avoid a huge budget blowout. Thus, politicians are likely to feel the brunt of the public's anger, with Prime Minister Gordon Brown and Chancellor Alistair Darling first in the firing line!

More: Start strengthening your savings today| Don't Panic About HBOS | Five Ways To Beat The Credit Crunch