How did the crisis start?
It has its roots in America’s housing market. Chasing profits, mortgage lenders gave loans to people who could not really afford them – the infamous “sub-prime mortgages”. When interest rates went up, borrowers could not keep up the repayments so many of these loans ended in repossessions. The problem was made worse when US house prices began to fall, leaving the lenders with properties worth less than the amount of the loans they had made.

Why is this problem affecting Britain?
The loans had been divided up by the mortgage companies into small parts and “securitised” – parcelled up into complex financial instruments called mortgage-backed securities that are traded among the banks. Think of it as an upside-down pyramid, at the bottom of which were the shaky foundation of sub-prime mortgages. The more US house prices fell, the shakier those foundations became.

The question of who was left to bear the losses, estimated at $300 billion, was initially unclear as the loans and the financial instruments based on them had become so complicated. This is because of “leverage” – a mortgage worth, say, $100,000 may be the basis for millions of dollars of mortgage-backed securities. Who owed what to whom took time to unwind.

This meant that bankers were left unsure as to whether their competitors were sitting on huge gaps in their balance sheets. They consequently became unwilling to lend to each other so the cost of borrowing money went up. The “credit crunch” began.

Did Northern Rock fail because it was facing heavy losses?
No. It got into trouble because it had lent a huge amount of money for mortgages compared with the amount it had taken in from depositors. This meant that it had to borrow money from other banks and financial institutions to ensure that it could meet its obligations. As the credit crunch took hold, such borrowing became much more expensive and difficult to come by.

When it appealed to the Bank of England for help, a run on the bank started as customers feared they would not get their deposits back. It needed a government guarantee, and eventually nationalisation, to survive.

A similar thing happened to Bear Stearns, the American investment bank, last weekend. In its case, a takeover by JPMorgan Chase, a rock-solid US bank, was quickly engineered to stop the problems spreading.

How is HBOS linked to all this?
In such a febrile atmosphere, rumours of problems can have a devastating effect. On Wednesday, unknown traders spread stories that HBOS, Britain’s biggest mortgage lender, had some undeclared losses on its books. They were untrue but wiped £3 billion off the bank’s value in an hour’s trading as the shares tumbled. The Bank of England had to issue a statement saying there were no problems at HBOS to stop the shares falling further.

Could it happen again?
The HBOS drama showed that the financial markets are prepared to believe that almost any bank could be in trouble.

On Thursday the Bank of England met the five main high street banks and agreed to provide them with more funds to ease the credit crisis. How effective this will be the next time rumours start remains to be seen.

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