Andreas Whittam Smith: The financial crisis is moving into its final phase

Everybody wanted to get out, including the depositors of Northern Rock

The financial crisis, which has been running since last summer, and whose most notable incident thus far has been the failure of Northern Rock, is entering its most dangerous phase. On Thursday, there collapsed a £5bn hedge fund, Peloton, based in London.

There is a sequence to these episodes. They start with a major event that alters the economic outlook – the coming of the canals, or the railways, or the motor car, or the internet that led to the dotcom boom and bust. It could be the outbreak of war or the end of war. In this case, it was the arrival in financial markets of the massive savings being accumulated by oil-producing countries and fast-growing Asian economies. This is the passing of power from west to east.

A bit of this wealth went into fine art, another slice into acquiring trophy assets such as football clubs, famous hotels and stores and even media companies. Much more was invested in stock markets everywhere and, finally, a lot was directed by the banks towards real estate.

In particular, enormous sums were lent to home owners in the United States and in Britain, with very enticing terms being offered to first-time buyers. These mortgages were parceled up together and sold on by the banks to investors all round the world who were looking for a return that was better than that provided by a boring deposit.

Peloton owned billions of mortgage-backed securities. If you had been able to untie these packages, take out the individual mortgages and examine them, you would have found that a proportion exceeded the value of the property that was pledged as security, that borrowers' ability to service their loans had not always been checked properly, and that, in some cases, crucial documents were missing.

If you had begun to suspect fraud, you would not have been entirely wrong. Everything depended upon an assumption that was rarely challenged, another invariable feature in these histories. In this case, it was the notion that house prices would continue to rise and never decline. If this had indeed been the case, then borrowers would always have been able to refinance themselves and avoid trouble.

In fact, US home prices peaked in the second quarter of 2006 and started to go down. Immediately, borrowers began to default. Those who had risked nothing, not having been required to put down a deposit, had nothing to lose. The UK is running some 15 months behind, with the peak occurring in the third quarter of 2007. Seeing these trends, unsure of whether they would persist, the crisis began with the usual period of self-questioning and doubt.

If readers will forgive me for quoting myself, I reflected this mood last July when I wrote here that:"I could go on to describe the horrible consequences of risky borrowers proving even less reliable than assumed... I could illustrate how financial fear spreads like the Black Death. But I won't do so because little has gone wrong so far. The financial storm I espy is still well out to sea. It could lose momentum or change direction. Or it could hit us full on".

However, in early August there came the event that precipitated the crisis: the failure of a small German bank because of its over-indulgence in mortgage-backed securities. The storm had come onshore. Everybody wanted to get out, including the depositors of Northern Rock. There are various labels for this stage. It was once called "discredit". A more common word is "revulsion". I prefer a German phrase, "door-shut-panic" or Torschlusspanik.

There began a desperate period when central banks and the commercial banking community each tried to smother the crisis, as if fighting a fire. The central banks reduced interest rates and lent liberally to the commercial banks. This has not prevented them from jacking up borrowing costs and savagely restricting credit. As Peloton's managers admitted ruefully: "Credit providers have been severely tightening terms without regard to the creditworthiness of individual firms".

At the same time, large international banks tried to form a syndicate that would buy securities from hard-pressed investors, but they couldn't agree terms between themselves.

So now we have reached, I believe, the most testing time of all. Sales of mortgage-backed securities at any price have become more common in recent weeks. Peloton itself has been dumping its holdings onto the market. Values are tumbling. Fire sales are taking place.

This process will further damage the balance sheets of banks and hence their ability to provide credit. This may well precipitate a recession. But there is one small comfort. The period of forced selling, however long it may last, is the final stage of the crisis, the climactic event that brings it to an end.