A financial crisis that began in the US is coming to a home near you

As American banks admit the billion-dollar scale of their losses, Bank of England Governor warns that the worst is still to come in Britain
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The Independent Online

No one knows where the bodies are buried. Indeed, no one is quite sure exactly how many bodies there are. But they are out there, and there are plenty of them: underperforming loans, worthless securities and overvalued assets, all safely buried well away from the banks' balance sheets. Buried – but not quite dead.

Increasingly they are surfacing, and these financial zombies are every bit as frightening as any you'll encounter in a horror flick. No less terrifying are the other ghouls haunting the global economy: oil at $97 (£46)a barrel; the price of commodities from copper to wheat at historic highs and a White House seemingly intent on scaring everyone witless with the prospect of a fresh conflagration in the Middle East.

The Governor of the Bank of England has been spooked already, telling us yesterday that: "I think most people expect that we have several more months to get through before the banks reveal all the losses that have occurred... There is always, in a period like this, the possibility that a shock from outside the UK, one from the world economy, might create further fragilities". The "fragilities" have been exposed in some of the world's biggest banks. Their bosses have been the biggest casualties, comforted only by compensation packages running into hundreds of millions of dollars – remarkable even by the standards of Wall Street.

Still, such numbers are trivial compared to the losses banks are beginning to reveal, mainly down to their enthusiasm to lend to the "sub-prime" market – people who should never have been granted mortgages in the first place. Now these unfortunates are seeing their low rates of interest run out, they are having to refix at far higher rates and are defaulting and pushing the American real estate market into a slump. Packaging up these loans and selling them on seemed a good idea at the time – it spread the risk and offered investors "superior returns". Not any more, though: at a guess, some $15bn of losses at Citigroup, even though the bank pitifully admits it isn't quite sure if that's the lot; perhaps $8bn at Merrill Lynch; thus far $4bn at UBS. There will be more. Much more. Despite assurances from the Chancellor about the strength of our institutions, the hunt is on for the next victim. Barclays? Alliance & Leicester? Royal Bank of Scotland? They could suffer from buying too many of these defaulting loans. Or, like the case of Northern Rock, they may be hit by the credit squeeze, as banks hoard cash to deal with any nasties that emerge. In these circumstances they won't lend to each other, are less willing to lend to the "sub-prime" market and mainstream borrowers – businesses and families – may also find it harder to arrange that overdraft or car loan.

When the other banks refused to fund Northern Rock anymore, it had to go the Bank of England and the Treasury to help it keep going. How sure can we be that it was the last such institution to find itself distressed? What will happen to the banks then? And confidence in the economy? Will we be able to spend and live as well as we have? The inescapable conclusion is "no". Given that consumer spending accounts for two-thirds of the economy, any slowdown in consumer credit is going to have a dramatic effect.

True, consumer debt, including mortgages, has arguably reached unsustainable levels – about £1.3trn, slightly bigger than the UK's GDP – and thus some moderation in that is desirable, if not inevitable. However, the speed at which the economy may be required to make this adjustment could prove a shock to a system long accustomed to easy, cheap money.

It would be quite a deceleration, a sort of emergency stop. The economy has been travelling at a formidable pace; growth this year will probably exceed3 per cent, high by historic standards and far above its long-term trend rate. Next year the more optimistic estimates see growth running at 2.25 per cent; not bad, but quite a jolt.

However, that annual figure covers a story of two halves; the first months of 2008 will be propelled by the momentum generated so far. The second half, and beyond, may well witness a lower rate of growth than 2 per cent. If so, it will not qualify for the title of "recession" but it will feel pretty bad.

Where the pain will be most felt can be predicted with some certainty. The top of the London property market is one potential victim – but also at the bottom end, where our own "sub-prime" borrowers will find themselves refixing at higher rates where budgets are already tight. As the housing market stumbles further, so will spending and investment. The volatility of the stock markets could hurt investors. It could be a horrific year. The bankers' pain will be shared by us all.

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