Andreas Whittam Smith: There's a storm brewing – and it's coming this way

A financial storm, well out to sea when I wrote about it two months ago, is now coming onshore. The Bank of England, in its role as coastguard, said cautiously on Thursday: "It is too soon to tell how far the disruption in financial markets will impair the availability of credit to companies and households". House buyers already have some idea. They are finding it more difficult to arrange mortgages than it was before the summer holidays. And although the official rates have remained stable, the cost of home loans has risen a touch. On the other hand, while the stock market has been weak, nothing serious has happened thus far. Yet, as I shall explain later, the wind is rising and the waves are growing larger.

What did the Bank mean when it talked about disruption in financial markets? In fact, it is referring to something I have never seen before. Respectable, well established banks are refusing to lend to each other for short periods unless rewarded with super-high interest rates. They have stopped trusting each other. The reason is that they realise that there is some £500bn of bad debt somewhere in the system, but they don't know where it is. It comprises so-called subprime mortgages that have fallen into arrears – "subprime" because the American home buyer who took on the loan was known at the time to be a poor credit risk.

You might wonder why on earth the problems of American home buyers have anything to do with us. To explain this, a bit of history helps. Once upon a time, financial institutions which specialised in making home loans retained the business on their books from the day the young couple walked through the door and asked for a mortgage until the moment when the loan was repaid. People with a low credit rating were turned away. Then a financial technique with an ugly name, securitisation, was developed. This meant that the lender could sell its existing book of loans to other financial institutions. And this same package of loans could be sold on again and again. In this way, British institutions such as banks, pension funds and insurance companies ended up owning American housing debt.

From the point of view of the original lender in the United States, this selling on was an attractive transaction because it now had funds for further business and could extract a fresh set of fees for new customers. It was likewise pleasing to the purchasers of the loans, for the mortgages appeared safe and marketable while providing a better rate of interest than available elsewhere. Then things got out of hand. Suddenly finding themselves able to fund themselves from global financial markets rather than exclusively from local sources, the American mortgage institutions went after every piece of business they could find, dropped their standards and started to do a lot of subprime lending. Investors around the world, assured that even subprime loans had an acceptable default rate, greedily took everything that was offered to them.

Unfortunately, interest rates started rising and the American housing market weakened. Subprime loans began to go wrong. Sometimes they were poorly documented. The shocking result is that some 15 per cent of all subprime lending has developed, as the Americans put it, "serious delinquencies". Aggregated together, that is what the £500bn of bad debt mentioned above comprises. The first casualty is the American housing market, where activity has been sharply reduced and prices are under pressure. In turn, this is helping to drive the US economy into recession. That was the shocking prospect that spooked stock markets on Friday.

The second casualty might be as serious – the world's credit markets. The central banks have been trying to ease conditions by making billions of pounds of very short-term funds available. This is not working because the underlying problem is not so much a shortage of liquidity as a lack of information. Where are the bad debts? Alas, no institution with a substantial holding of subprime mortgage paper wants to disclose its position before it has to do so.

What are likely to be the consequences? The shortage of credit will mean that high-risk borrowers will have to pay a lot more for loans than those with a good credit rating. At the extreme, some who could have borrowed money before the summer may find that they cannot do so any longer. They may have to sell assets. There will be fewer debt-financed takeovers. Governments and central banks will find it difficult to undo the credit crunch that financial institutions will have brought upon themselves. It's the hangover after the party. It is not a mere indiscretion, however. For as a result, some sort of recession, and with it a stock market correction, is almost certainly on the way.

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