Paying the price of the bankers' folly

For those working in the debt markets the summer has been torrid, confidence has evaporated and right now no one wants to lend to anyone anymore. As a result the bids and deals and the borrowing and lending that have fuelled such a splurge of profitability in the past few years have ground to a halt. Less activity does not just mean lower bonuses, it also means that done deals can start to unravel. As a result, fortunes have disappeared overnight while banks and hedge funds slowly own up to horrific losses and terrible misjudgments, which in some cases have wiped out all their investors' capital.

Like most of the bad weather that comes to these islands,this crisis started across the Atlantic and has bad loans and mortgages in the American housing market at its core. But because financial markets are global, the leading British banks and Barclay's in particular have been caught up in the storm, albeit through their own fault.

Banks no longer just collect deposits and lend money in the local high streets. They deal in vast sums with each other and the leading corporations of the world, and very many more which traditionally would never have been considered as safe enough to loan money to.

The key change is that banks used to agonise over getting their money back These days, though, they reckon they can lend what they like because they will be able to parcel up the debt and sell it (and the risk of default) to someone else with more money than sense. So for the past five years they have played passthe-parcel, lending money rashly and taking fat fees and commissions for slicing the loans up, mixing them in with others and feeding them into the market to non-bank investors.

Where it went wrong was that everyone got too cocky. Selling on bank debt can in moderation be a good thing because it spreads the risks more widely throughout the financial system. But what happened was that the quality of lending fell because the banks no longer had to worry if they would get their money back.

Collective insanity spread right across the markets. None of the buyers thought about what was actually inside these packages because they too were confident they would not be holding the parcels when the music stopped, or because they thought the music would play for ever.

Once people in financial markets think they will not be held responsible for their actions, there is an accident waiting to happen. Last month it did. Now the banks are struggling to come to terms with the monster they have created.

Debts they thought they had got rid of are coming back to haunt them as people fail to meet payments, renege on promises made when times were easy and generally can't or won't pay up when they should. As a result many of the banks look to be stuck with what is often described as toxic waste financially poisonous collections of debt that are highly unlikely ever to be repaid in full.

While they are all desperate to look superficially calm, underneath our bankers are trying to work out what to do with this rubbish and agonising over how to pay for it.

At this stage no one thinks any British banks will go bust or anything like it though some small German banks have already had to be rescued but the costs could still run into billions. No one knows what the real picture is, but confidence has taken a nasty knock because of the uncertainty.

Barclay's epitomises the problem. Its executives say that their risk of losses is minimal and there is nothing to worry about. But then Barclay's goes and does things borrowing £1.6 billion overnight from the Bank of England or pouring another billion in to support a hedge fund which appear anything but normal.

So it could be weeks or even months before a clear picture emerges. This matters because it is not just a financial market problem. However far the markets may appear to float free from the real economy, the debts do ultimately have an effect on ordinary people's mortgages. For while the banks can afford the losses, there is still the problem of displacement.

If they have to use up their money to re-finance these mountains of rubbish there is going to be far less of it around to lend to other more deserving causes. This is where the problem in the financial markets crosses over and begins to affect the real economy and people who have had no responsibility for what has been going on.

It takes time to work, though nine months to a year is a popular estimate but it could then easily mean that mortgages and other loans could become scarcer. Even if the money is still available, it is likely to be more expensive. A lot of firms and individuals who have become used to getting more credit as and when they want it are in for a rude awakening.

This is where is gets interesting. British economic growth these past 10 years has been largely fuelled by borrowing and the extra money that has put in people's pockets. It follows that if the extra money is no longer available, people can't spend as much, retail and other sales will drop and the whole economy will slow down. It does not necessarily mean there will be a recession, still less a crash in the housing market, but it does mean people will feel worse off.

This could be a real challenge for Gordon Brown. At some point he is going to have to call an election. As he is comfortably ahead in the polls, there is a lot of speculation about a snap election this October. The natural time for an early election would be next spring. But next spring could also be when the effects of today's financial crisis begin to have their impact in the wider economy. He could be going to the polls just as the voters feel poorer. That, for Labour, could also be a very toxic package. October rarely feels the most cheerful month.

But it could prove less chilly than the spring, when ordinary voters start to feel the effects of the bankers' folly.

'Many of the banks are stuck with what is described as toxic waste - financially poisonous collections of debt unlikely ever to be repaid'