Anatomy of a credit crunch

A young couple in Kansas find they over-reached themselves with that $200,000 mortgage on a new home last year, and default on the latest monthly payment.

On the other side of the Atlantic, executives at Cadbury Schweppes are informed that the planned $16bn sale of the company's US drinks division is not going smoothly and may even have to be scrapped.

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Extraordinary as it may seem, the first leads directly to the second. It is global finance's version of the butterfly effect, the idea that the flapping of tiny wings in one part of the globe could lead to a chain of events that culminates in hurricanes elsewhere.

And there are hurricanes in the debt markets at the moment. After years when companies and private equity firms have been able to get their hands on trillions of dollars of debt at very low interest rates, suddenly the money is drying up.

"You have had a big meal, and you are suffering indigestion afterwards," says Mark Howard, co-head of research at Barclays Capital in New York. "Sometimes it takes one pill for the indigestion to go away, sometimes it takes several pills. It doesn't mean the system doesn't work, but it just means everything will be at a different price. It has taken the stock market a long time to come round to understanding that."

The turmoil in the debt markets has been building for several months, and some players have suffered eye-popping losses running into tens of billions of dollars. Until very recently, these losses have been confined to some esoteric corners of the financial world. But in the last few days, the effects have been bleeding into the real world.

The reason is that if access to cheap debt is cut off permanently, it will mean an end to all the activity that has been funded by the cheap debt. Share buy-backs that have propped up company share prices - over. Big bets on the financial markets by highly-leveraged hedge funds - over. Most worrying of all, the wave of takeovers by private equity firms - over.

Cadbury Schweppes has been hoping to sell its drinks business, which includes 7Up and Snapple, to one of a number of interested private-equity buyers, but suddenly none of them may be able to afford it. Cadbury's banks are offering to lend buyers the money, but they have been forced to offer substantially less generous terms on the loan. The company's shares were down 4 per cent yesterday, and it was hardly alone. On both sides of the Atlantic, many share prices are inflated by hopes that private equity may come to take over the company. These are beginning to deflate.

Also skidding downward yesterday were shares in the Wall Street banks, who have profited handsomely from lending to private equity, trading on behalf of hedge funds, and advising companies on takeovers, and who may bear the brunt of the losses from the current debt market storm.

We're not in Kansas anymore. But how do we get from there to here? In years gone by, our young couple may not have been able to get a mortgage at all, since they are clearly risky, "sub-prime" borrowers. Now, though, they are vital cogs in global finance.

Their mortgage lender actually sells the debt almost straight away to the big Wall Street banks. Millions of these mortgage debts are pulled together, into collateralised debt obligations (CDOs), which are sold on to investors such as hedge funds. Our couple's new home, then, is in fact collateral for some fragment of a debt that might be held anywhere in the world.

CDOs perform something akin to magic. Because their mortgage is lumped in with other, different types of debt, our couple's individual default shouldn't affect the ability of the CDO to pay interest. The CDO has a higher credit rating than our couple ever would, and investors will pay handsomely to hold it. By last year, demand for CDOs reached $489bn, three times as much as in 2004.

But our young couple is just one of tens of thousands of American homeowners defaulting on their mortgages, and arrears are at all-time highs. Meanwhile, in many parts of the US, house prices are slipping, reducing the value of the collateral. Suddenly, investors have lost faith in the magic of CDOs, and are questioning whether they are really worth paying handsomely for.

Demand has slumped, the values of the CDOs held by hedge funds have collapsed, and many of those funds are sitting on huge losses. Last month, two hedge funds run by Bear Stearns admitted they had lost all of their value - a massive $20bn wipeout.

Equity market investors started worrying about "contagion" from the US sub-prime mortgage market in March, but persuaded themselves the panic wouldn't spread. After the spring dip, global stock markets resumed their upward march. Investors were too sanguine.

The Bear Stearns trauma has caused a big rethink throughout the system. The Wall Street banks that lend money to hedge funds have stopped doing so as freely, and everyone has become a lot more risk-averse. The hedge funds now have less cash - and less nerve - for holding other types of collateralised debt, including the debt used by private equity firms to fund corporate takeovers.

The risk-taking hedge funds that have been the end buyers of debt in recent years are "in a world of hurt", says Barclays' Mr Howard. The question is whether they have gone for good, in which case borrowers will have to rely on traditional banks, finance companies and institutional investors to fund their takeover activity - and these traditional lenders will be demanding much higher interest rates and business guarantees.

At the moment, financiers in the City of London and on Wall Street are taking a wait-and-see approach. Earlier this week, the banks underwriting KKR's £11bn takeover of Alliance Boots postponed their sale of £5.1m of debt. Banks for Cerberus, the private-equity firm buying US car maker Chrysler, also postponed a $12bn fundraising. Both will come back again in the autumn, in the hope of getting better terms then. In neither case are the bankers yet panicking that they won't be able to sell the debt at all. Even if they can't, keeping the debt on their own books is not necessarily a disaster.

However, the Wall Street banks are already drawing in their horns, reducing the amount of money sloshing about the system. Until they are certain that the end buyers have returned, they are not advancing bridging loans to private-equity firms on such generous terms. There is also anecdotal evidence that they are refusing to bankroll the creation of some new collateralised loan obligations (CLOs), which are sliced-and-diced debt products similar to a CDO, which parcel out debt in private equity-owned companies. In other words, throughout Wall Street, the taps are being turned off.

Tobias Levkovich, Citigroup's chief strategist, is in the camp that says it is temporary. After all, company profits and cashflows are still very strong, the global economy robust. Debt may not be dirt cheap again, but interest rates are still low by historical standards. The private equity-fuelled mergers and acquisitions boom will continue as long as the underlying company is able to generate substantially higher returns from its business than the interest rate that must be paid on its debt.

"To be sure, when this gap closes, we will become more concerned about the M&A activity support structure beneath the market, but we simply are not there yet," he told clients yesterday. "There may be more fuss than substance to the recent step-up in investor anxiety."

Mr Levkovich is joined by pretty much everyone on Wall Street in keeping his fingers crossed. As for our couple in Kansas, they may be left wondering about the connection between Wall Street's voracious appetite for debt, and the fact that they were lured into a risky house purchase that has caused them such personal misery.

Alliance Boots

KKR's £11bn takeover of Alliance Boots, owner of the chain of high-street chemists, is the biggest private equity deal ever in the UK. KKR is paying cash, using a bridging loan put up by a consortium of investment banks including Deutsche Bank, Royal Bank of Scotland and Barclays. Their attempt this week to sell a £5bn tranche of the loan in the debt markets was met with little interest, at least at the price they were hoping, and they will keep it on their books instead.

UBS

In May the Swiss bank shut its Dillon Read hedge fund business, run by John Costas, left, a humiliation for the bank and one of the reasons it sacked its chief executive, Peter Wuffli, two months later. Dillon Read had been given $3bn of its parent company's money to play with in the financial markets, and quickly suffered $124m losses, mainly through wrongheaded bets on debt instruments backed by sub-prime mortages.

Manchester United

The cash-guzzling football club, which has been on a spending spree on new players this summer, is believed to have put plans to refinance its £660m of debts on hold, due to choppy conditions in the global credit markets. The football club had been talking to a number of banks, including JP Morgan and the Royal Bank of Scotland, over a potential refinancing. A spokesman for the Glazer family, who own Manchester United, said that the club was not under any pressure to complete a refinancing this summer.

Chrysler

Daimler, the German car giant, will have to stump up still more money to offload its loss-making American division Chrysler after Cerberus cancelled a $12bn (£5.85bn) debt fundraising with which it was hoping to cover restructuring costs at Chrysler. In May, Daimler agreed to part with Chrysler in return for €1bn (£670m) in cash from Cerberus, a token sum that was not enough to cover losses from that date until the deal's expected closure next month. This week, it emerged that Daimler and Cerberus will jointly hand Chrysler a $2bn loan, money that Cerberus had hoped to find in the debt markets. A further $10bn in loans will be kept on the books of the Wall Street banks which are underwriting the deal.

Bear Stearns

The high-flying Ralph Cioffi, a respected veteran of the mortgage-backed bond market, was running two hedge funds for Bear Stearns, in which some $20bn of bets had been placed on the direction of the sub-prime market. The bets went wrong, and banks which had lent most of that money demanded it back. Outside investors in the fund also clamoured to take their remaining cash out. An attempt to raise cash by selling the collateralised debt obligations inside the funds found no buyers and Mr Cioffi had to admit his funds had been wiped out.

New Century Financial

The Californian mortgage lender filed for bankruptcy protection in April. As house prices have fallen in some parts of the US, arrears have soared. New Century is the largest of three dozen non-bank lenders to sub-prime customers who have either gone under or had to put themselves up for sale.