The foreclosure butterfly flapped its wings in smalltown USA and the hurricane built up and tore through world banking. Iain Dey reports

Cathy Busby has never met Mick Mayor. The 47-year-old hospital administrator from Colorado had no idea that when she fell behind with the mortgage payments on her three-bedroom home in the Denver suburbs, it would stop Barclays extending the overdraft limit on Mayor's business four months later.

But this is the true story of the global credit crunch. What seemed initially to be a problem in the US housing market is now forcing up the cost of borrowing here in Britain, having swept from Denver to Darlington.


A prospective buyer views a repossessed property in Denver which has one of the highest foreclosure rates in America

Cathy is just one of several hundred thousand American homeowners to have become caught up in what is now known as the US sub-prime lending crisis. In spring 2005 she remortgaged the home she had lived in for 11 years and in which she raised her two sons. She borrowed $170,000, the value of the house at the time, to help pay off student debts, a car loan and other personal borrowings. She knew the 7.6 per cent interest rate she had been offered was scheduled to jump sharply after two years. But she had assumed she would be able to find a new deal, with a new lender, when the time came around.

What she hadn't banked on was the value of her home slumping to $125,000, leaving her with no prospect of refinancing a new loan an agreeable terms. Her monthly mortgage payments jumped from a little over $1,000 a month to more than $1,500. With a monthly salary of $4,000, this was too much to take. On May 1, Cathy joined the long list of American homeowners to go into arrears and begin the process of repossession - a list which is expected to stretch to more than 2m names within the next 18 months or so.

Meet Jimmy Cayne. He's one of the biggest big shots on Wall Street: the chairman and chief executive of the investment bank Bear Stearns. Cigar-chomping Jimmy is estimated to be worth about $1.3bn, and likes to spend a lot of time on the golf course. He plays bridge with Warren Buffett and Alan Greenspan. Curiously, Jimmy's life has been turned on its head by the problems that people like Cathy have suffered.

Two hedge funds managed by Bear Stearns owned billions of dollars worth of sub-prime mortgages, just like the one loaned on Cathy's home. The funds held them through complex financial instruments known as collaterised debt obligations (CDOs), which had been used to parcel up portions of all kinds of debt.

The securities held by the funds were supposed to be ultra-safe, and had AA or AAA credit ratings. But when mortgage defaults began to rise, it became apparent that some of these ratings were a little optimistic. By the middle of June, rival banks Merrill Lynch and JP Morgan Chase were trying to get their money out of the crumbling Bear Stearns funds.

While dozens of mortgage lenders across the US had been forced into bankruptcy by the sub-prime fallout, this was the first real evidence of it washing up on Wall Street. The global fear rating had just been pushed up a notch.

Cayne eventually agreed to pump $1.6bn into one of the funds to stave off collapse. "I'm angry," he said shortly afterwards. "When you walk around with the reputation for being the most rigorous risk analyser, assessor, controller and that is trashed, well you have got to feel bad. This is personal."

It turned out to be even more personal for Warren Spector, Cayne's $36m-a-year golden boy and heir apparent. Spector was forced to carry the can for Bear's excesses and was promptly shown the door. Cayne shot an 88 round at the Hollywood Golf Club in New Jersey the following day - a sharp improvement from 102 in the depths of the crisis.

Cayne was not the only one being spanked over sub-prime losses. CDOs such as those linked to the Bear funds had been sold to investors all over the world.

The CDOs with exposure to dodgy US home loans had been used as collateral against assets held in other CDOs. All these positions were leveraged. When the defaults began to show up they had a knock-on effect on funds that initially seemed unrelated. That started the panic.

Hedge funds were being forced to put up money against losses they were making on CDO investments. They raised the cash by selling equities and high-grade bonds - assets that investors were still willing to buy. The FTSE100 was kicked into a downward spiral, along with every other major equity index. Suddenly, what had started as an obscure issue in an ethereal branch of finance was headline news, beaming into living rooms across the country.

Problems began to appear in the Canadian banking system. Then the Bank of China put its hand up, admitting that it was exposed to almost $10bn of US sub-prime loans. This was global contagion.

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