FTAdviser.com

Advertising

When the first mention of a US sub-prime crisis began making its way into the headlines, I doubt many people knew what it meant or even cared.

Six months later however, ‘credit crunch’ ‘credit crisis’ and ‘financial turmoil’ all carry so much more meaning, and not just to those involved in the financial services industry but also to the average person on the street.

In fact, it has become such a widespread concern that Facebook has launched a credit crunch application and the website creditcrunch.co.uk has dedicated itself solely to it.

So what exactly is it?

Also known as a ‘liquidity crisis’ or ‘credit squeeze,’ it’s when the banks won't lend or indeed can't lend because they’re having difficulties obtaining funding themselves.

It then becomes more difficult for consumers to borrow money because of the stricter lending criteria, even for those with the best of borrowing track-records.

Consumers in turn begin spending less in the 'real' economy and businesses start making cut-backs putting economic growth and stability in jeopardy.

Northern Rock

Problems first began in the UK in September 2007, with the first run on a British bank, Northern Rock, for over a century.

After learning of the bank's funding difficulties and unstable financial position, thousands of distressed savers queued to withdraw millions of pounds from Northern Rock.

Today the bank is worth little to nothing and has been nationalised by the British government. (See recent story.)

Sub-prime lending

But the problems did not start here. The credit crunch first raised its head in the US, which had been having problems of its own as a result of over-subscription to sub-prime lending.

Massive growth in this sector meant that people with poor credit histories and low incomes found themselves able to get a mortgage, whereas before they had simply been excluded from the market.

This drove demand for houses to all time highs, but as default rates on these mortgages increased, the US housing bubble began to burst and its current credit crisis began to take hold.

Global crisis

These rising defaults on sub-prime mortgages in the US have triggered a crisis for global money markets, with banks all over the world left exposed.

The credit crisis, stock market jitters and rising commodity prices have provoked the US Federal Reserve to cut its interest rates aggressively in a bid to turn its flailing economy around, but despite the measures, US house prices have continued to drop.

The final straw that made the world realise that the end of the economic boom had come, was the collapse of Wall Street giant Bear Stearns.

The bank collapsed because other banks lost confidence in the value of its investments in sub-prime mortgages, and a few weeks later it was bought by JPMorgan Chase. (See related article.)

Crunch time

According to the International Monetary Fund (IMF), global growth is projected to slow to 3.7 per cent in 2008, one and a quarter per cent lower than the growth recorded in 2007, with a 25 per cent chance of a global recession.

The US is tipped to fall into a mild recession, although some argue that it has done so already.

The UK however, is expected to fair better that the US and other G7 countries with the general consensus amongst analysts being that economic growth will slow only to around 1.6 per cent for 2008 and 2009.

David Kern, economic adviser to the British Chambers of Commerce, said: "In 2007 the average rate of growth in the UK was 3 per cent and that is expected to halve in 2008 and 2009 with the second half of 2008 expected to be the weakest."

According to Ed Stansfield, property economist for Capital Economics, the credit crunch is set to last at least a few more months yet, given that the market hardly reacted to the Monetary Policy Committee’s (MPC) Base Rate reduction in April.

At the beginning of April, the MPC opted to cut interest rates by a mild 25 percentage points, bringing the headline rate to 5 per cent. It is the third interest rate cut since August 2007, when the credit crunch first started getting its teeth into the UK.

Despite the interest rate cuts though, many lenders have been reluctant to pass them on, or at least straight away, so many consumers are not benefiting from the drop in interest rates anyway.

And to top it all off, lenders all across the country are pulling mortgage products right, left and centre leaving a limited amount of choice in the market for the estimated 3 million homeowners coming off fixed rate mortgages this year.

All dried up

In fact, 100 per cent mortgages are no longer in existence in the UK at the moment, preventing most cash-strapped and deposit-less first time buyers from entering the property market.

Latest research from Moneysupermarket.com puts the total number of mortgage products currently available in May 2008 in the UK at 5,417, compared with 6,824 available the month before.

One year ago, in May 2007, there were 27,105 mortgage products available in the market.

What is worse though is that the number of mortgage products available for first time buyers has also dropped dramatically with 2,963 available in May 2008 down from 3,746 in April 2008.

This compares with May 2007 when there were 16,858 first time buyer mortgage products available in the UK market.

Commenting on the difficulties facing UK consumers, head of mortgages at Moneysupermarket.com, Louise Cumming, said: "There’s going to be a lot more emphasis on customer loyalty going forward and lenders will only lend to customers they know. We have started to see that with already with First Direct." (See First Direct story.)

According to Cumming, it is likely that lenders will get even more choosy about who they lend to looking to ensure customers are tied into other products with them such as current accounts that they must pay their salaries into. They are also likely to push up their rates of interest as well as arrangement fees.

"Lenders will probably get choosier about intermediaries and choose large ones to deal with and ones that have introduced good quality clients to them before," she added.

The end of the housing boom?

Despite all this doom and gloom however, there are still some quarters that believe the credit crunch is actually a good thing, especially if it brings down house prices.

The Roof Affordability Index compiled by housing charity, Shelter, suggests that house prices for first time buyers throughout the UK have risen 200 per cent in a decade with the average first time buyer house price at £159,494 in 2007. In London this rises to £260,000. (See related story.)

The latest Halifax House Price Index in May 2008, said that the average price of a UK home is now £189,027. (See story here.)

With prices like these, its no wonder some people are hoping for a house price crash, but so far, the credit crunch has yet to make a big dent in UK house prices with prices falling by only 1.3 per cent in April, the Halifax said.

But if Kern, the economic adviser to the British Chambers of Commerce turns out to be right, then house prices could fall by as much as 10 per cent by the end of 2009.

“London house prices are still strong and what happens here depends on the financial sector but if there are continued problems in this industry London could take a hit,” he warned.

Some though, still remain upbeat though about house prices and according to the National Association of Estate Agents (NAEA) house prices will make a recovery towards the end of 2008.

Many analysts are predicting that the downturn in the UK economy will be mild with the US shouldering most of the burden.

But there is also wide agreement that even if the UK does escape the worst of the credit crunch, the UK mortgage industry will take a very long time to recover.

What next for the mortgage industry?

The Association of Mortgage Intermediaries (AMI) is just one quarter concerned about the long-term damage to the mortgage industry.

"Our biggest concern is how the pendulum will swing. In one sense it used to be too easy to get credit, the swing may first go to the extreme whereby lending becomes too tight until the balance is restored,” said Chris Cummings, director general of the Association of Mortgage Intermediaries (AMI).

"The result will be regulatory change, damage to confidence levels and detriment to consumers."

In fact to protect lenders and intermediaries alike, he said that it was essential that lenders keep their distribution channels open during these turbulent times, so that when the market recovery begins, lenders still have broad geographical coverage.

"Lenders will bounce back quicker if they have kept open relationships with intermediaries," he added.

Stansfield is also not very optimistic about the market and says it’s hard to imagine the mortgage market returning to its previous volumes or style of lending.

"For now it looks like this is consigned to history but that’s not to say that in 12 years or so we could find the mortgage market returns to the way it was a few months ago," he said.

And to top it all off, the Council of Mortgage Lenders (CML) believes net mortgage lending could halve in 2008, unless the Bank of England takes broader based action to prevent this.

“We would like to see more liquidity auctions, of higher amounts, over longer terms and available to a wider range of institutions,” a spokeswoman for the CML said. (See CML story.)

Can the UK escape recession?

With all that is going on in the UK, the burning question now, is whether a recession in this country can be avoided.

Stansfield believes that in the current climate, there is a one in three chance of the UK falling into recession in the next two years.

"But we are a long way from this at the moment," he said.

Kern, tends to agree with him: "We’re not looking at a 1990’s slump," he added.

But with the markets still jittery and conditions changing everyday, what situation the UK will be in, in one year, is really anyone’s guess.