The situation has the potential to get a lot worse.
Umi is correct in what she put, but it goes further. - although the banks provided the packages to the mortgage and loan dealers in the first place.
The big issue now is one of trust, and that is why the market is collapsing.
"Big finance" needs vast amounts of cash available for very short periods in order for it to work. So a FTSE 100 company might borrow hundreds of millions of pounds, but pay it back within hours or days as it juggles the numbers on it's books. This is called the "Commercial Paper market - CP "
banks do the same, but with a lot more "things" than just commercial paper. Over the last 10 years, one of the things they have used a lot is these "packages" of loans or the shares that are sold from them. This isn't new though. These packages of mortgages have been around for 100 years, it's the new ways of splitting them up into stocks and shares that is fairly new.
The whole system is based on the assumption that about 1:100 mortgages will fall into debt. Over the last 20-odd years, it's been better than that - about 0.3%.
Now, with rises in interest rates and a slump starting in the economy - the general 7 year slump which no government can ever fix - it's built into the system - those mortgages are defaulting. The issue is that becuase of lax controls about WHO could be given a mortgage or a loan - which I think is fairly difficult to regulate - the figure of 1% default is now in question.
The big question that the banks are dealing with is "What is the actual level of deafult going to be?". And, becuase of all these new fancy ways of splitting up the packages of loans and mortgages, that is now very hard to work out. When you have a share which is a derivative of a put call on an index which tracks a variable set of these packages, it is virtually impossible to work out.
So a given bank MIGHT be technically bankrupt. Or it could be exposed to only an exceptionally safe set of of these loans and mortgages. but as it's almost impossible to know, and no one knows which specific mortgage will default - the banks have lost trust in each other.
This means that they are no longer as willing to lend each other money for short periods, which the whole financial system is based on, as they can no longer trust that the bank they lent to will be still there tomorrow morning.
It's all about confidence, and the sudden lack of it.
Without the ability to loan cash short term, banks get into difficultys. Which is why Northern rock went pop, becuase it had to borrow from the bank of england. The EU forced the BoE to make that public, the media spun it, and there was a run on the bank.
A similar situation with HBOS and B+B, but HBOS was ( for now, but now lloyds is looking shaky ) was rescued.
Up until this point - it's scary but to the man in the street, not a real issue - as long as you don't have more than £35,000 of savings in a single bank, as it's all insured.
The tim it gets bad is when this shakiness, and lack of confidence, starts to affect the Commercial Paper - CP - market, that non banking companies use. This started to happen a couple of days ago, but went away within a few hours. But if i happens for a long period, then the "normal" businesses can no longer finance themselves, and even healthy businesses will crash. This is what happened in 1929, and why it was so bad.
As long as the panic stays in the banking sector, we'll get away with just a recession. If the madness hits the CP market, then it's a depression or worse.
What does this mean to the "man in the street"
Short term - not a lot. Your savings are safe. And if you have an OK credit rating, then your very valuable right now, and so no on will dare tamper with your fixed intrest mortgages or loans.
Variable rate mortgages are controlled by something called the LIBOR rate. This is rising, so there may be small rises in variable rate mortgages.
Medium term - inflation
The government didn't have the money it payed for B+B and Northern Rock "at the back of the sofa" - it just printed more money, which it;s perfectly entitled to do. However, all that money is now whizzing around the economy. Well, at the moment it's not whizzing anywhere, but when the short term crisis is over, it will start to move.
Inflation is caused by having too much money in the system, or the money moving around too quickly. The government has had to pump billions into the system, and that will force inflation up a fair bit.
That will be countered by the bank of england pushing up interest rates to try and halt it. And at this point, people with mortgages and loans will feel the pinch.
If you have big mortgages or big loans, now is probably an excellent time to see a financial advisor. They will probably try to get you onto fixed rate deals while it is still cheap.
<<Qualification here - this is NOT financial advice. It's personal opinion. But it never hurts to see an IFA >>
Hope this is vaugely interesting
Steve