What’s the problem on Wall Street?

America’s banking system has stopped working. It is clogged up by billions of dollars of bonds, secured by defunct mortgages, which nobody wants. Many banks hold these bonds on their books and the size of their investments is so large that it threatens to bankrupt them. Two banks, Bear Stearns and Merrill Lynch, have been forced into distressed sales this year and another, Lehman Brothers, went bust ten days ago. The remaining banks, such as Morgan Stanley, are scared of lending to each other in case another collapses.

Paralysis on Wall Street affects the world banking system because it means that US companies will not be able to borrow to help them to grow, ordinary borrowers will have difficulty getting mortgages and credit and banks outside the United States will be hit by their exposure to their rivals in America. As a result, stock markets in London, Hong Kong and Tokyo are suffering. Such volatility scares investors about the safety of all their investments and the swings have triggered massive withdrawals as savers rush to switch into cash or Treasury bonds.

What does Washington want to do about it?

President Bush wants to implement a series of rescue plans devised by Henry Paulson, his Treasury Secretary, a former chief executive of Goldman Sachs. Mr Paulson wants to use $700 billion of taxpayers’ money for two years to buy these distressed bonds. He proposes to put them into a federal-backed fund, which would be controlled by the Treasury. He hopes that once the market recovers, the fund can sell the bonds back into the market and claw back some of the $700 billion. He has asked Congress to approve the rescue package within a week.

Why all the fuss?

The bailout will cost every American taxpayer $5,354. There are also fears that the $700 billion will not be enough. Others are concerned that while Mr Bush has promised that the fund would not spend more than $700 billion, if the money were to be used as a rolling credit facility, the liabilities of the fund would be far bigger, exceeding the value of the annual budget of the Pentagon.

The creation of such a fund would make the US Treasury Secretary the most powerful in American history. He decides who runs the fund and how much they are paid. While Mr Paulson agrees that there should be oversight of the fund, that has not, as yet, been set up.

Americans are worried that taxes will have to rise to pay for the bailout. They are also angry that Wall Street bankers, who created these distressed bonds and who previously made huge profits, are being bailed out by ordinary people.

There are fears that the bailout will not work because it will fail to inject confidence into the financial system and that the economy will suffer a catastrophic meltdown.

Bankers and lawmakers are anxious that Washington is nationalising a chunk of Wall Street and that such a move will set a precedent, with other distressed industries begging for state help.

Will the President get his way?

Probably, but with strings. It will be tough getting Congress to vote on the bailout and have it signed into legislation by tomorrow, a schedule that Mr Paulson had set. But most of the sceptics understand that a bailout is urgent.

How would the bailout fund work?

This is the $700 billion question. Nobody, including Mr Paulson, quite knows. Broadly, he wants to hire Wall Street advisers – probably the very financiers who created and traded these distressed assets in the first place – to tell him the best way of valuing and buying the bonds. He will hire managers to control the fund and decide when to start selling the bonds back into the market.

Because they are presently untradeable, some banks believe that the bonds are worthless. However, Ben Bernanke, the Chairman of the Federal Reserve, has indicated that the fund will pay a far higher price than the market value – the value of the bond as it would stand at maturity. This would stop banks having to take huge writedowns on their assets.

What other steps have been taken?

Mr Paulson announced a $50 billion fund to support the American money market mutual fund industry, which holds deposits worth $3.5 trillion. The US Securities and Exchange Commission imposed a ten trading-day ban on “shorting” shares in 799 financial companies.

Times Recommends

• Toyota recalls 437,000 cars including Lexus
• Myners says bonuses are bleeding pension funds
• Japanese company faked safety reports on seats