When they come to write the history of the credit crunch, the collapse of Carlyle Capital Corporation will get a chapter all of its own. What started as an innocuous offshoot of the American buyout group has overnight turned into one of the most high-profile and catastrophic failures of the crunch so far.

That Carlyle, one of the world's largest and most influential private equity groups, could not rescue its mortgage-backed fund speaks to the sheer panic sweeping through global markets.

Banks had every reason to help Carlyle. CCC was one of 60 funds owned and managed by the respected Washington-based group. Over the years, banks have earned millions (probably billions) in fees from Carlyle, so it was in their interests to work hard to get a deal done.

But in the end, so great was the fear gripping Wall Street that one by one all 14 of Carlyle's “relationship” banks decided to pull the plug. And where Carlyle has fallen, dozens of others are now set to follow.

Like Peloton Capital before it, any highly leveraged funds invested in mortgaged-backed securities will now inevitably topple. And the higher the leverage, the bigger the fall. As Carlyle's bruises show only too well.

But even despite the leverage, CCC seemed doomed to fail. Carlyle's defence - that its assets are AAA and US government-backed - no longer appears to hold water.

As quickly as CCC was issuing statements to reassure investors that its assets were solid, so the price of the securities were falling in front of their eyes.

Even as Carlyle finally agreed to pump in additional equity, the value of AAA assets had dropped far enough to make its fresh cash injection worthless. In the end, it had no choice but to throw in the towel.

What's now clear is that the contagion of sub-prime has moved to prime and, with it, billions of dollars worth of carnage will follow. As more than $16 billion of Carlyle's assets hit the market, prices will fall further and other banks will rush to liquidate their positions in the stampede for cash. It's a self-fulfilling prophecy.

Witness Drake Management, the New York-based hedge fund that has warned it may have to close its fund, and GO Capital Asset Management, the Amsterdam investment group that has frozen its $881 million fund. And sources say several hedge funds in London are facing a funding squeeze by their credit providers.

One by one, the funds will be forced into messy and public liquidations. But bad news for the hedge funds isn't good news for the banks. First, they have to sell the assets in a market where there are no buyers. And that means discounts. And discounts means losses. And as more assets get sold, the price falls further and the losses potentially get bigger.

Some banks may opt to sit on the assets instead and try to bide their time, hoping for a recovery, but that seems unlikely. All but a few are up to their necks in AAA rated securities and no one, it seems, is in the mood for sitting and waiting.

For consumers, the more pain the banks feel, the tighter they turn the screws on lending. They're pretty tight already but as funds like CCC collapse and banks are forced to mark their losses to new market prices, or realise the losses in real time, the screws will only get tighter.

In turn, mortgages will get harder to come by, consumers will spend less, default more and confidence (already battered) will fall farther. Throughout this credit crisis, it's been hard to pick where the next ugly monster will rear its head. Creatures have come out of the woodwork that most of us had never even heard of.

But one thing's for sure. As the economy suffers and consumers spend less, private equity begins to look more and more vulnerable.

Billions of dollars worth of deals were done in the heyday - all using mountains of cheap debt and only the tiniest slices of equity.

Until now, to a firm, they all insist the underlying companies are still good, despite the bonds trading well below par and the equity, for the most part, being under water.

But if the consumer stops spending, in time, companies such as Alliance Boots, bought last year by private equity giant Kohlberg Kravis Roberts, (KKR), will begin to suffer.

And if the banks refuse to go easy on Carlyle, there's no way they'll go easy on KKR either. A collapse of that magnitude could easily be the next chapter in the credit crunch book.

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