Can we really have witnessed the demise of three top investment banks in so short a time? Bears Stearns, Lehman Brothers and Merrill Lynch have all disappeared off the radar in quick succession.

What is happening to the world’s — and especially the American’s — financial system?

It started with the slicing, dicing and splicing of U.S. mortgages of sub-prime customers. The structured financial instruments that were sold off around the world became known as CDOs (Collateralized Debt Obligations).

They have poisoned the world’s financial system, like seeping toxic waste. Now a new danger is forming on the horizon.

CDSs (Credit Default Swaps — insurance policies for bonded commercial IOUs), which are out there in their trillions and trillions, are beginning to crumble in the face of massive defaults.

The world’s biggest insurer AIG is already in Lehman territory — its shares plummeted by 70 percent in early trading yesterday. The long-foretold CDS crisis is with us at last.

So what precisely are CDSs and how will their demise affect most of us in coming days, weeks, months and years?

George Soros estimates that the value of CDSs now equals half of U.S. household wealth, an almost unimaginable number — let’s call it $23 trillion.

CDSs are hedges made by investors in case a company defaults on its debts. In effect you bet on a company failing to protect your investment in the event it does just that. The problem arises when large numbers of companies go bust and the CDSs themselves become worthless since no-one can pay them out.

A CDS seller undertakes to compensate a buyer if a corporate bond defaults. Since there is no limit to the size of cover taken out, the value of CDSs often exceeds a company’s debts. Moreover, many CDSs are bought with borrowed money so the infection of the system drives deep into the financial heartland like veins in a blue cheese.

The danger now is debt deflation: a rapid reversal of debt issuance, or deleveraging as it is called.

Tim Congdon of the London School of Economics says, “Banking system capital is being wiped out. The risk is that this could lead to a contraction of credit and set off a self-reinforcing downward spiral, leading to the sort of debt-deflation we saw in the 1930s.

“It is already clear that money growth has ground to a halt over the past three months. We must prevent it from actually contracting. If the Fed and European Central Bank don’t cut interest rates soon, it is going to be a problem.”

The Bank of England’s rigid inflation target, set by Gordon Brown when inflation was low, is now a millstone round Mervyn King’s neck at a time when energy, food and commodity price rises are being imported from global markets.

The Eurozone is similarly caught in a time warp relating to Germany’s neurotic fear of hyperinflation. Add the growing divergence between euro economies and a far deeper than necessary downturn is guaranteed for Western European countries.

America is already suffering a double blow: the fading of the effect from the summer tax stimulus and a loss of export competitiveness as the dollar rises.

What began as bad government, worse regulation, grasping banks, financial structures that lacked resilience because they were built on sand, have left us with a perfect storm that is about to come ashore and swallow large parts of the economy.

In what seems to be a concerted action by the UK Treasury and the Bank of England, Bank Governor Mervyn King warned that pay demands for inflation-busting increases will be self-defeating if they trigger a rise in interest rates.

The Governor told the Treasury Select Committee of MPs that there is no magic bullet to protect workers from having their incomes squeezed by rising prices and interest rate increases. They could help themselves by avoiding excessive pay claims to cover the rising cost of living.

Cash-strapped families will find no shelter this year from rocketing oil and food prices.

“We are all in this together,” he said. “The most important thing is there’s no magic bullet that will protect the UK from higher oil and food prices imposed by the rest of the world. It is better than we face up to that now and recognize that fact, rather than pretend to ourselves that we can avoid it.”

MPC member, Tim Besley, said: “We have to adjust our living standards. One of the mistakes we can make collectively is to believe that by bidding up our wages we can somehow insulate ourselves from a global phenomenon – rising energy and food prices. If we do that that is a self-defeating process which will lead to higher inflation and wages will not end up being higher.”

Mervyn King said, “The cost of reducing inflation once it stays above the target for a period will be a very prolonged and deep slowdown in activity.”

With the housing market in meltdown, the next three years are set to be painful for everyone, with the possible exception of short sellers on the markets and the oil companies.

Ordinary folk need to batten down the hatches now, cut expenses to the minimum and protect their income sources as best they might. It’s not in the interests of the High Street, of course, but, for a few years at least, it’s everyone for himself.

One thing’s for sure, conditions will take the focus off rather abstract globalization matters, back to the real, local world that everyone lives in.