Commercial insurance article archive
The 2007 credit crisis - how far will it spread to the real economy?
How bad is it?
Worries of a stock market collapse following the US credit crisis have seemingly been allayed by a recent rally due to solid oil prices and positive corporate news.
Positive, that is, apart from those which the credit crunch may leave with a multi-billion-pound hole in their pockets - the banks.
Major banks in the City are now only lending to each other at the highest rate for nearly nine years as they protect their cash piles while the full extent of the US home loans crisis remains unknown.
Uncertainty over where exactly the packages of debt from the US sub-prime market have been sent and how much it totals has made banks in all financial centres jumpy - especially over suggestions there could be a black hole as big as £250 billion hidden in the balance sheets worldwide.
However, this reluctance to share the wealth between banks is reportedly harming liquidity and may bring about an economic slowdown next year.
An unnamed banker told the Guardian: "Everyone is concerned, everyone wants to see liquidity restored to the market and everyone has a role to play in that - issuers, central banks - in terms of doing smart things."
While the US Federal Reserve and the European Central Bank have released billions to keep the system flowing, the Bank of England (BoE) has refused to cut interest rates to aid the City as it continues to wage war against inflation.
Mervyn King, the governor of the BoE, defended its position in a letter to the chairman of the influential Treasury Select Committee which emerged today (12/09).
"The current turmoil, which has at its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long-term economic stability," Mr King said.
"The key objectives remain, first, the continuous pursuit of the inflation target to maintain economic stability and second, ensuring that the financial system continues to function effectively, including the proper pricing of risk."
But he warned: "'If risk continues to be under-priced, the next period of turmoil will be on an even bigger scale."
This view is supported by economists at the Levy Economics Institute at Bard College, New York, who last week published a study titled 'Cracks in the Foundations of Growth' which demonstrated that the current crisis could pose a danger to US economic growth.
According to the study, a decline is inevitable even if bail-outs from the banks go continue.
But the experts suggested the best way to avoid a full recession would be the introduction of a debt relief programme in the US to help the estimated 2.5 million people at risk of defaulting on their mortgage payments and continuing the downward economic spiral.
"An effective job-creation method could be some form of employer-of-last-resort programme that offers government jobs to all workers who ask for them," they suggested.
Even if a recession does not come to pass, a bail-out of the financial system on some scale "will probably become unavoidable", according to analyst Wolfgang Munchau of the Financial Times.
But he suggested this would not be such terrible news as "it should be accompanied with structural policy changes" - including a tightening on lending regulations and a re-evaluation of the monetary policies of central banks - which should help prevent a repeat of the mistakes which led to this credit crunch.
Effects on the housing market
It seems difficult, however, to have much sympathy for banks that have been placed in a somewhat nervous position after many were involved in causing the messy situation in the first place.
But the spiralling effects on other sectors of the economy seem particularly unfair.
Although sub-prime mortgages in the UK are now under scrutiny, they have had little impact on the overall housing market.
But the collapse of the US sub-prime market has already been so influential as to force notoriously resilient London house prices into their first fall for a year.
A report from real estate website Rightmove showed a 0.1 per cent slip in the average asking price for homes the capital to nearly £395,000 in August.
East London's Tower Hamlets had previously seen rapid price growth as it will host part of the 2012 Olympic Games, but it experienced the biggest monthly decline of 6.9 per cent.
And even properties in the priciest borough, Kensington and Chelsea, fell one per cent to an average of just under £1,450,000 as the area's bankers felt the looming threat of much smaller bonuses come the end of the year.
Across England and Wales, four out of ten regions experienced a price drop in August, according to Rightmove's research, as sellers moderated their demands in light of the recent financial unrest.
And with the BoE holding rates high, or even contemplating a further rise to six per cent, there will likely be fewer people looking to enter the market and prices will drop further.
However, the Bank's monthly assessment of mortgage rates in August noted that lenders had not yet matched the 1.25 per cent rise in rates since July 2006.
New fixed rate mortgages were found to rise only 0.59 percentage points to 5.58 per cent over the period, suggesting that borrowers may still find good deals - but also that the pinch may be on its way.
Despite these agreeable mortgage terms, such has been the gloom cast over the market that buyers have been scared away, choosing to wait out the storm in the hope of finding cheaper properties on the other side.
According to the Royal Institution of Chartered Surveyors (Rics), new buyer inquiries fell away rapidly in July to a level not seen since August 2004.
"The combination of softening demand and supply is causing market conditions to weaken further," said Jeremy Leaf, spokesman for the industry group.
"Buyer activity has pulled back a little over fears that we may have seen the top of the market."
Further concerns have been raised by the introduction of home information packs to the market, but Rics noted that demand continues to be fuelled by a shortfall in available property which may give prices more resilience than buyer confidence would suggest.
Unfortunately, the same cannot be said for the American housing market where prices were already much cheaper and have been pushed lower still by the spate of repossessions following the sub-prime scandal.
The Standard and Poor's housing index for the US reported a 3.2 per cent fall in home prices over the previous quarter - which amounted to the largest drop since that measure was first recorded in 1987.
And the index's committee chairman, David Blitzer, could not even offer a silver lining to the report, saying: "We still don't see anything that looks like a clear bottom...we're still headed down."
Effects on the wider economy
Even though the US housing market's troubles are seemingly deeper than those back across the Atlantic, the credit crunch has shown that there is little refuge from today's worldwide economy.
The slight downturn already experienced in the UK property markets have undoubtedly been affected by the events in America, while the pressures on the financial sector may see City bonuses dry up and even lead to job cuts.
According to the Guardian, some investment banks have stalled all hiring of new staff in middle and back office areas as a precaution, while the loss of bonuses would seriously dilute the exceptional house price growth recently experienced in the capital.
But a downturn in the City could even have implications on government spending, as it has become such a large source of tax revenue for the Treasury and the financial uncertainty comes as Alistair Darling, the chancellor, is still pondering the details of his comprehensive spending review.
John Hawksworth, chief economist at leading City firm PricewaterhouseCoopers, told the Guardian that despite recent record tax takings, "there may be some concern that the current budget still appears to be slightly in deficit" and that the problems in the finance world may lead to reduced revenue from the sector, threatening the public purse further.
With such wide-ranging potential implications of the sub-prime crash and still so much uncertainty over which areas will be hardest hit, the predictions of the experts at the Levy Economics Institute seem more reasonable.
And this is not even having taken into account the threat that US consumer spending could dry up if the country's housing market downturn continues apace.
Even America's largest mortgage lender is concerned that an economic recession may be around the corner, with Angelo Mozilo, chief executive of Countrywide Financial Corp, saying the current situation is "one of the greatest panics I have ever seen."
And he added that the general public are likely to be just as panicky as those in the financial sectors.
"I can't believe ... that this doesn't have a material effect ... on the psyches of the American people and eventually on their wallet."
This has put added pressure on the US president, George W. Bush, to take drastic action to restore consumer confidence and not just trust the Federal Reserve to prop up the financial markets.
But with the UK and the rest of the world seemingly intertwined with the combusting American economy, it may be that Dubya's actions, or lack of them, have large-scale economic implications.
13 Sep 2007