Everything you want to know about the bank crisis

As the financial crisis enters what the governor of the Bank of England has called a "new and dangerous phase" Iain Macwhirter has been looking at the big questions

How bad is it?

This is the worst financial crisis in 60 years, and it has shaken the banking system to its foundations. Even the Chancellor, Alistair Darling, has compared the crisis to the Great Depression and he is not given to overstatement. Banks are in the business of lending money they don't have - it is called "fractional reserve banking". But every so often the banks succumb to irrational exuberance, lend too much and find their reserves have been eaten up too fast, forcing them out of business. This is what happened to Northern Rock, and is now happening to all the big banks. That is why they had to be rescued to the tune of £50bn last month by the Bank of England - ie, us. They will be back for more.

Do the banks know what they are doing?

Well, they know now. During the house-price bubble, the banks were lending recklessly to people with no prospects. In the US it was called "sub-prime" lending, and amounted to organised fraud. Loans were knowingly given to "Ninjas" - people with "no income, no job or assets" - who could never hope to repay them. Britain too had sub-prime lending. At the peak of the boom UK banks offered "suicide loans" of up to 120 per cent of the value of the house with only self-certification of income. The mortgage holders were in negative equity as soon as they got the keys. These people are in real trouble as mortgage rates rise and house prices fall. Northern Rock lent out roughly 200,000 of these in the two years before it went bust and had to be nationalised. This makes the government the biggest holder of sub-prime mortgages in Britain.

How could the banks be so stupid?

Partly this was down to the delusion that house prices could only ever go up. But the other reason was a practice called "securitisation". The banks packaged the dodgy loans into interest-bearing bonds and sold these to financial institutions across the world. This took the loans off the banks' balance sheets and allowed them to lend even more money they didn't have. The banks thought, wrongly, that they no longer bore the risk of default on these mortgages because they had been sold on to other people. This was a big mistake. The debts came winging back. Now the entire financial system is in cardiac arrest because banks no longer trust each other.

Didn't the regulators see this coming?

Regulators such as the Financial Services Authority and the Bank of England were asleep at the wheel. The Treasury, Bank and FSA are run by relatively low-paid civil servants who are in awe of financiers and their lifestyles. They believed that the banks were run by masters of the universe who knew what they were doing, with their mathematical formulas and leveraged deals. In fact they were run by bonus-greedy wide boys, who gave no thought to the future and had no concept of social responsibility. The City bonus culture encourages short-termism and risk-taking. It was in these people's interest to pretend the credit boom could go on for ever, and that securitisation had taken the risk out of lending money. They thought they wouldn't be around to clear up the mess. In fact, even when the roof did fall in, those such as Adam Applegarth of Northern Rock still got their pay-offs and bonuses - in his case a "golden goodbye" of £750.000. Shareholders seem unwilling to curb the greed of the new generation of CEOs who run City firms. The regulators don't even try.

Does this affect my savings?

The good news is that the banks want your money, so they are putting savings rates up. The bad news is that most of the banks are in effect insolvent and are posting epic losses on their irresponsible lending. Many are in danger of going out of business, but the Bank of England doesn't admit it for fear of causing panic. However, the collapse in the share prices of banks such as Royal Bank of Scotland and Halifax Bank of Scotland tells you all you need to know. The entire banking system of Britain is now on life support from the state and even the Bank of England's reserves are not unlimited. If your bank goes under, only the first £35,000 of your savings are secure under banking laws. The only bank that gives a 100 per cent guarantee of depositors funds is, paradoxically, Northern Rock, which is government-owned. Perhaps the government will nationalise more banks if they go bust. But maybe it won't be able to.

Is anywhere safe?

At times like these investors reach for so-called "safe havens" - assets that tend to rise as the value of currencies falls and provide a hedge against inflation. Precious metals are the most obvious, which is why gold rose to more than $1,000 (£500) an ounce recently, though it has since fallen back. Oil has become a hedge, which is why its price keeps going higher. Many UK pension funds and investment houses are putting money in commodities such as wheat, rice and other foods in the belief that they can only go up and up. Most of us would think that profiting from starvation is morally reprehensible, but the market doesn't do morality. And be warned: commodity prices can go down as well as up. The safest haven is National Savings and Investments index-linked savings certificates, which everyone should hold.

What else can individuals do?

There's really no way of heading off the debt nemesis. Britain is even more indebted than the US was at the height of the boom. Personal debt here has risen to £1.4trn, and house prices rose by even more absurd multiples than in the US. British property is overvalued by 30 per cent, according to the International Monetary Fund. This could mean another trillion wiped off the total value of British homes, now worth around £3trn. The only way people can protect themselves is to pay off all their debts, fast. People living in houses larger than they need should consider selling before prices fall. First-time buyers should not under any circumstances be encouraged into the market, even if they can find a mortgage. Avoid discretionary spending, such as those silly sandwiches we buy for lunch, because you will need the cash to pay for higher food prices. In most parts of the country it is a lot cheaper to rent. Joining a car club can save thousands.

What is the government doing?

The government thought it could jump-start the mortgage market by giving a £50bn bung to the banks in an attempt to reignite the housing boom. It will regret it. It was irresponsible of the Bank of England to accept the banks' dodgy mortgage bonds in exchange for billions in cast-iron Treasury bonds because the banks know that their mortgage bonds are largely worthless, otherwise they would have offloaded them by now themselves. The banks will be back for more as they post more losses. The governor of the Bank of England has made a point of saying there will be no financial cap on the bonds-for-gilts swap.

Why is the government bailing out the banks?

The default position in the Treasury is that house prices will always go up in the end. It hoped the banks would return to lending to first-time buyers, the housing market would revive and consumers would again be able to use their homes as cash machines. It is not going to happen. Abbey put its rates up even further on the very day the banks left No 10 with £50bn in their back pockets. The banks know that house prices will fall sharply over the next two years and are withdrawing from the home lending business.

If we finance the banks, can't we tell them what to do?

Gordon Brown should be asking that question! The neoliberal thinking that has dominated the Treasury for the past two decades sees no role for state intervention - except to pay the banks when they get into trouble. It is socialism for the banks; capitalism for the rest of us. Moreover, there is a disturbing overlap between the higher levels of government and the big banks because of the privatisation of aspects of the state through mechanisms such as the PFI/PPP. It is no accident that when Tony Blair left office he walked into the Wall Street bank J P Morgan for a reported salary of £2m for a part-time job.

What about the US Federal Reserve?

The Fed was captured by the banks a long time ago, which is why it has pursued reckless policies such as negative interest rates, which benefit Wall Street but not main street. The Federal Reserve became a cheerleader in the creation of the debt society and largely created the house-price bubble that has now burst with spectacular consequences. After the dotcom crash of 2000, the then Fed chairman, Alan Greenspan, held interest rates far too low for too long. The US, like Britain, became a nation of property speculators. Everyone thought that as long as house prices rose, Americans could keep spending, even as middle-class incomes stagnated in the 1990s. Now it has collapsed, Greenspan's successor, Ben Bernanke, has tried to save the banking system by inflating another bubble. But cutting interest rates has not worked. The cost of borrowing has actually increased.

What does it mean for the global economy?

The global dimension is truly worrying. World trade is still fairly buoyant even as the credit crisis deepens, but no one expects this to last. China and India are still heavily dependent on American consumers buying their cheap TVs and toys. If they buy less, these economies will be put under severe strain. What is most worrying is the stability of the global market in financial deri vatives. The market in these exotic financial instruments is now worth some $500trn - nearly ten times the value of all the companies on the world's stock exchanges. The US investment guru Warren Buffett has called these derivatives "financial weapons of mass destruction".

What is to be done?

The days of laissez-faire in international finance are over - or should be. The banks have admitted that they cannot be left to regulate themselves and have had to be bailed out by the state in one of the greatest financial rescues in history. The banks have been given free access to public funds in a way that the British manufacturing industry never enjoyed in the Seventies when the UK still made things. The credit crisis has destroyed the intellectual credibility of neoliberalism. This is a turning point in world affairs and in economic and political thinking. The free-market orthodoxies of the past 30 years have crashed and burned. However, change will not happen of its own accord. If the government had the will do to so, it could emulate the policies of President Franklin D Roosevelt in the 1930s and regulate the economy in the national interest. This will mean tackling social inequality, the bonus culture and the lack of accountability in financial services. Instead of just propping up bankrupt banks, the government should be democratising them - mobilising their assets to stimulate the productive economy, repairing infrastructure, researching and developing new markets and refitting the western economies to combat climate change. It does not have to be like this. But without change, we will just go into another cycle of financial boom and bust.

Iain Macwhirter is an award-winning political columnist for the Herald

http://www.newstatesman.com/200805010022