We didn't (quite) have brokers hurling themselves out of 37th-storey windows but the near-collapse of US investment bank Bear Stearns last month triggered a wholesale panic on world investment markets.

Analysts who just a few short months ago were discounting the possibility of a US recession were running for cover and tossing out terms like "depression".

Investors were left pondering whether the world was coming to an end or whether it had simply gone mad.

Welcome to a bear market. These unpleasant periods are characterised by fear, uncertainty and predictions that life will never be the same again. Negative sentiment is the trademark of a bear market and it often seems that investors are actively looking for reasons for markets to fall.

Unfortunately, bear markets don't just come out of nowhere. There are generally good reasons for investors to be nervous - though full understanding tends to come only with hindsight.

For investors trying to work out where they stand now, the big question is: what has gone so dramatically wrong since the first signs of the US subprime crisis emerged last year? How did a problem with dodgy loans in the US housing market develop into a worldwide financial crisis and claim corporate victims in Australia in areas as diverse as property trusts and child-care centres? And what do hedge funds, short selling and margin loans have to do with it?

Let's start with the big question. Why has a problem with a small proportion of US mortgages created such havoc?

Blame globalisation and financial deregulation. Lending used to be simple. Customers deposited their savings with the banks, which then lent the money to people who needed it to buy houses, fund businesses or whatever. All that has changed. Those cheap mortgage rates we've enjoyed were just one outcome of the growing use of wholesale funding by banks and other institutions. Instead of holding loans on their own balance sheets, lenders packaged up loans and sold them to a growing range of investors looking for a better yield than they could get on standard fixed interest investments like government bonds. Thanks to low interest rates there was a seemingly endless market for this debt, with takers including super funds, hedge funds, financial institutions and even local councils and foreign governments.

But as always happens when there's lots of money looking for a home, promoters of debt investments got more and more creative. In the US subprime market, lenders were writing loans that borrowers didn't have a hope of repaying. Many of these loans were packaged up in sophisticated vehicles such as collateralised debt obligations which offered a high yield. These often included a mix of loans, leaving investors unclear on just what they were investing in.

When the crisis first hit the news last August, most financial institutions and investors felt perfectly justified in saying, "We don't do subprime lending." But as the situation unwound, it became clear that subprime debt had spread further than anyone realised.

Peter Hilton, the head of Australian equities with Bridges Financial Services, says: "The problem was exported around the world because these loans were parcelled up and sold to more institutions and banks than anyone could guess.

"It became a guessing game because the banks all lent money to one another and were always doing business with one another. No one knew where all the subprime stuff was and they probably still don't."

Those freewheeling debt markets virtually dried up as banks became concerned about counter-party risk. "Banks would say that the institution they were dealing with may have subprime exposure and so they'd charge them a higher interest rate," Hilton says. "They wanted to be compensated for the higher risks they were taking and so credit spreads and the costs of funding blew out the door."

Colonial First State's head of investment markets research, Hans Kunnen, says banks have become increasingly reluctant to buy anyone else's debt - especially since the big US banks reported large subprime losses in January. "Even major Australian banks are reluctant to buy other banks' bonds," he says.

Is that why banks have been getting into trouble? It's at the root of the problem. We still haven't seen the full impact of losses from the subprime crisis. The US investment giant Goldman Sachs estimated last week that Wall Street banks, brokers and hedge funds may report $US460 billion in credit losses from subprime mortgages - or almost four times what's already been disclosed.

But it's the freezing of credit markets that is really exacerbating the problem, because credit isn't always available when it's needed - even at higher rates.

The market for some debt securities has virtually disappeared. In Australia we've seen non-bank lenders such as RAMS run into problems and others, such as Macquarie, exit the mortgage market because of a lack of access to funding. Goldman Sachs says the availability of credit is likely to tighten further as institutions suffering subprime losses pull back their lending to preserve their reduced capital and maintain their statutory capital adequacy ratios.

But AMP Capital Investors' head of investment strategy, Shane Oliver, says loss of confidence is the real problem.

"The loss of confidence in credit markets has made the losses greater," he says. "Investors have become sceptical of any loans or deals they didn't originate themselves. That's generating rumours and in cases like Bear Stearns, institutions are finding they can't get capital when they need it."

How serious is the problem? Surely suggestions that this is the worst crisis we've seen since the Depression go too far? Fat Prophets' head of Australasian research, Greg Canavan, says the Bear Stearns collapse marked a new phase in the credit crisis, with the US central bank, the Federal Reserve, kicking in to help rival JP Morgan take over the investment bank, thus averting its collapse. "Put simply, Bear Stearns, or any other large commercial or investment bank, is too big to fail completely," Fat Prophets wrote in a special report.

It says Bear Stearns demonstrated how interdependent financial institutions around the world have become, especially with the widespread use of derivatives. The global derivative market is estimated to be worth about $US45 trillion. "Derivatives are a zero sum game, whereby gains and losses ... cancel each other out. [But] for this system to work, counter-parties need to remain solvent," the report said.

"Bear Stearns was a major writer of derivatives, which is why JP Morgan moved so swiftly to reassure Bear's clients that it would stand behind the bank's obligations."

Canavan says the Fed's actions in helping to bail out an investment bank (as opposed to traditional banks) demonstrates the severity of the crisis. The big difference between the 1920s and today is the willingness of central banks to address the problems before they spin out of control. Even before the Bear Stearns bail-out, central banks had been pumping billions of dollars into the financial system to provide much-needed liquidity.

Britain's and Canada's central banks have joined the Fed in cutting interest rates and Britain acted to nationalise mortgage lender Northern Rock when it ran into liquidity problems last year.

"It's fair to say this is the worst crisis we've seen in credit markets but credit markets weren't as big as they are now in the 1920s," Oliver says. "They've really only arisen since the 1980s."

He agrees the present crisis is bad but Oliver says comparisons with the Great Depression are "ridiculous".

"In the first 10 months of 1930, 744 US banks went bust," he says.

"Bear Stearns ran into trouble but its counter-parties were rescued by the Fed. In the 1930s Americans were losing their deposits as banks went bust, the sharemarket fell 80 to 90 per cent, industrial production fell 25 per cent and unemployment went up to 30 per cent.

"One thing that does give us confidence is that the Fed keeps pulling out every trick in the book to stablise things. That didn't happen in the 1930s or in Japan in the 1990s, when the central bank kept lifting interest rates to bust that country's bubble and the economy plunged into a period of rolling recessions and deflation. The Fed understands those lessons and will do everything it can to stop a repeat of them."

Can we avoid a recession? When the subprime crisis first hit, many analysts believed the problems wouldn't spill over into the wider economy. That proved too optimistic. With some US households unable to pay their mortgages and forced sales putting pressure on house prices, it was always likely consumers would rein in their spending.

That drop in consumption - along with higher oil prices and the problems in debt markets - has brought the US to the brink of recession and led many to believe a US slowdown is inevitable. Standard & Poor's New York economist, Beth Ann Bovino, says real GDP in the US increased just 0.6 per cent in the last quarter of 2007 and is expected to drop in the first half of 2008. "The odds that an actual recession will result have risen to 70 per cent," she says. "But even if there is no downturn officially, it will feel like one to most Americans."

Kunnen says the situation in Australia is quite different. "In lifting interest rates, the Reserve Bank has made the point that our major trading partners are doing quite well," he says.

Rather than being concerned about recession, our central bank wants to slow the economy to ease building inflationary pressures.

"The Reserve Bank has been raising interest rates for a while but it has got particularly aggressive in recent months," Kunnen says. "It put out a statement in February saying its forecasts for economic growth had been 4.7 per cent in September but it wanted to slow that to about 2.75 per cent by June."

We're not immune to what happens in the US but Kunnen says it would take a major recession or "hard landing" in the US to derail growth in emerging markets such as China and India and, in turn, create real problems for Australia. "China and India aren't completely decoupled from the US but they are less 'coupled' than they were," he says. "Chinese growth is largely based on fixed-asset investment [such as building local infrastructure] which isn't dependent on US consumers." Thanks to its booming economy, he says, it also has the money to fund these investments.

Oliver says the other main risk is that the Reserve Bank will "overdo it on interest rates" and cause problems for Australian households. He says high levels of household debt have made Australian households more vulnerable to less favourable economic conditions.

Why has the sharemarket fallen so much? Kunnen says rising interest rates and the Reserve's intention to slow growth have forced investors to rethink their expectations of profit growth. Rising oil prices and a shortage of skilled workers are also increasing company costs and dampening profit expectations.

But the credit crisis is also taking its toll. Select Asset Management's chief investment officer, Dominic McCormick, says the subprime crisis acted as a catalyst for investors to reassess risk across a whole range of investments. Easy money and boom times had led investors not to worry too much about the downside of their investments but the subprime crisis was a harsh reminder that if you're going to take high risks, you need high rewards.

He says growth in investment markets was increasingly being funded by debt. This was evident in the highly leveraged private equity deals that dominated the market through much of 2006-07 and the popularity of products such as margin loans and geared investment vehicles. As credit markets have contracted and interest rates have risen, many geared investors have become forced sellers.

Hilton says it's like "a global margin call" and anyone who owes debt where repayment demands can be triggered is vulnerable - especially if they have a dubious business model.

Just as rising debt fuelled the boom, Hilton says reducing debt - or "de-leveraging", as the latest buzzword has it - is exacerbating the losses.

The ugly face of this de-leveraging has been the string of corporate victims such as Allco, MFS, Centro and even ABC Learning. But Kunnen says companies across the board are finding that when it comes time to refinance their debts, they're having to pay a higher interest rate.

McCormick believes the pain being suffered by retail investors is also more widespread than many people think.

"Because our market has had a benign 15 years where leverage has worked well, it has created excessive levels of debt where investors were setting themselves up to be hurt," he says. "We had got to the view that gearing suits everyone.

"At the retail level, our market was more geared than in the US. Products such as geared share funds don't exist at the retail level in America and margin lending is limited to 50 per cent, and it's a high-net-worth thing."

McCormick says many geared products are structured so that they have to sell when prices are falling. Margin loans are the classic example. If the value of your investment falls and you can't top up your equity, the lender can sell some of that investment. Calls on margin loans held by key shareholders were responsible for driving down the value of several of the high-profile corporate casualties of recent months.

But McCormick says structured products are also forced sellers. He says geared share funds, for example, have maximum gearing levels that they must maintain, while products offering capital protection go to cash as the market falls.

McCormick believes forced selling has been the major factor driving the market down, despite all the talk about hedge funds and short sellers.

"In certain company situations, short sellers have been a big factor but they haven't been a big factor in the market generally," he says. "There are valid concerns about the transparency of the extent of short selling and debt held by major shareholders but people are looking for someone to blame. They don't want to think their portfolio was too aggressive or too highly leveraged."

Is that why our market has fallen more than the US? McCormick thinks leverage is one factor but our market is also more dominated by banks and other stocks that are being squeezed the most by the debt crisis. Oliver says 40 per cent of our market is comprised of banks and financial stocks - such as investment companies and listed property trusts.

As with banks all around the world, Hilton says, Australian banks are having their margins squeezed by higher funding costs - not all of which have been passed on to borrowers. Our banks were also trading at a premium to other banking stocks, which has exacerbated their sell-off.

Our listed property trusts also have been hard hit because most of them geared up when finance was cheap to fund expansion plans.

"Listed property trusts were borrowing through commercial mortgage-backed securities which were offering lower rates than the banks," Hilton says. "But there's little or no activity in those markets now, the borrowings are becoming due and lenders want their money back. Those trusts now have to go to the banks and their cost of funding is higher."

Hilton warns that investors should also look more closely at unlisted property syndicates.

"A lot of money has gone into them in recent years," he says.

"They've offered high yields because of their ability to borrow at low rates. As these syndicates roll over, investors shouldn't anticipate the past will be a guide to the future."

Should I find that high-rise window? If the misplaced optimism of last year has taught us anything, it's the danger in trying to predict the future. What is clear is that the present credit problems are not going to disappear overnight. The supply of easy money has gone and the subsequent "de-leveraging" will be slow and painful. More subprime losses are undoubtedly in the pipeline and credit rationing is, to some extent, inevitable.

Even the optimists are now admitting a US recession is likely but the jury is still out on whether this will translate into a global slowdown.

S&P's Bovino believes the global economy could withstand a US recession, largely thanks to the strength of Asia, but warns a protracted US slowdown would have an effect.

She says a big danger is that the US relies heavily on foreign capital. With investors losing confidence in the greenback and US securities, that money is harder to come by. That could have longer-term implications for US inflation and interest rates.

Emerging markets and resources remain a beacon of hope but Hilton says commodity prices recently had their worst week in 50 years, while the Chinese stockmarket is off more than 30 per cent in the past month or so. He says both events have been due to speculation coming out of the market.

Oliver says the speculative flow of money into commodities became an avalanche in the past six months and this exuberance is due to be unwound but, in the longer term, commodity prices should remain strong.

"Australian equities may not be as good as they have been but they won't be ruinous," Kunnen says. "In the long term, if you look at how flexible and well-run the Australian economy is, you shouldn't be too worried."

Canavan says there will be some slowing in our economy but, with shares down about 25 per cent, a lot of the risks are already priced into the market.

Oliver says the next three to six months will be "pretty rough", with more bad news coming from the US and the effect of higher interest rates still to be felt locally. However, he believes the bulk of the damage has been done and things should improve by the end of the year.

"Corporate profit growth is going to slow," Hilton says. "Earnings in Australia and the US have been sensational, aided by strong consumerism and low interest rates. We're now seeing the flip side, and the question is how long it will last."

If you're interested in the banks, Hilton says we'll probably see "some pretty attractively priced rights issues before this is over" as banks shore up their balance sheets to meet lending demand.

McCormick says confidence will be a key issue and the loss of wealth by consumers (particularly if house prices fall) could slow demand and prolong any downturn. But he says there are still opportunities in the Australian market.

"There has been some panic-selling and some stocks get oversold," he says. "In the past couple of weeks we've seen people just giving up. That doesn't signal the end of the bear market but it does signal a rally is more likely, and that's what we've seen." (Also see story on page 12.)