Credit crisis - no end in sight?

The march away from credit

The Bank of England's latest warning over the far-reaching consequences of this summer's credit crunch has renewed fears that global financial systems are facing their biggest crisis in recent years.

Since August - when the US sub-prime mortgage market began to collapse and investors moved in their droves to shed high-risk portfolios - the world's money markets have faced an effective drying up of funds.

While America's low income mortgage holders were doubtless the first to feel the pinch, the effects of a global strain on credit have rippled around the world and the majority of UK consumers now also in one way or another find themselves affected by the credit crunch.

As recently as last week, five UK loan providers announced they were withdrawing their entire range of products - bolstering naysayers claims that the bottleneck will worsen before it gets better - and even among those able to secure a loan the rates have been driven up a crippling four per cent in just a matter of weeks.

Burgeoning interest rates have also taken a heavy toll on homeowners, with the British Bankers' Association revealing that the number of house purchase approvals fell a massive 27 per cent year-on-year in September, further isolating prospective homeowners from an increasingly unaffordable housing market.

And even major high-street lenders lack immunity from the squeeze - as shown by the run on Northern Rock two months ago - with the Bank of England now calling this the most severe challenge financial systems have faced for several decades.

"The speed, force and breadth with which these risks combined was not fully anticipated by the authorities or financial market participants," the Bank's half-yearly Financial Stability Review stated. "In consequence, confidence in the stability of the financial system, in the UK and internationally, has been dented."

You lend it, you bought it

Understanding why financial institutions are so jittery over the prospect of providing consumers and businesses the credit we all depend on - and in most cases are able to pay back - requires a brief overview of the practices and mechanisms that the world's money markets rely upon.

Rapid economic growth, strong corporate profitability and the expansion of personal wealth - all doubtless desirable trends - cannot occur without the overreaching spending power that easy access to credit affords us, whether we want to buy a home, take a much-needed vacation, or set up a multinational global corporation.

But when people start borrowing at unsustainable levels and when private equity funds and investment banks are allowed to resell those debts - which were never realistically going to be repaid in the first place - then you start getting into difficulties. And that's exactly what caused the US sub-prime crash that kicked off our current credit crisis.

The very thing that makes economies work so well - liquidity - also has the potential to be their downfall. And whereas in a more accountable financial system the buck would have stopped with the American sub-prime lenders who were issuing irresponsible loans to low-income families, under our current framework such lenders are frequently left unscathed.

Instead, investors who innocently tied up their money in complex portfolios - the precise contents of which they and even possibly the people selling them would have been unaware of - were the ones who footed the bill. That, understandably, spooked the investors, which led to an immediate drying up of funds and landed us firmly in our current credit-parched financial climate.

So because the lenders are now scared of lending they have duly backed away, raising their rates and adopting an altogether more conservative approach to issuing credit. But for the people on the other side of the equation - the low-income mortgage holders - scaling back is sadly less of viable option.

Mortgage defaults and the future of the credit crunch

The immediate impact of irresponsible lending paired with rising interest rates in the US inevitably and tragically hit the country's sub-prime mortgage holders the hardest, with the White House now estimating a total of 500,000 homeowners are set to default on their mortgage.

That disastrous collapse of low-end property is expected to have an immediate cost of $71 billion (£34 billion) on the economy, with a further $32 billion set to be wiped off the value of neighbouring homes and - some analysts warn - potentially ushering in a nation-wide crash in the housing market.

Whether or not the UK should expect disaster on a similar scale in unclear, but one thing all analysts now agree on is that British consumers' exposure to the risk of such a credit crunch depends as much on the practices abroad as it does at home. The fact that UK mortgage lenders are traditionally more cautious is essentially meaningless in staving off a similar crisis in the future.

So, where from here? Sure enough murmurings of a US-style property slowdown have already begun surfacing on our shores. UK home repossessions rose for the third time in a row in Q3 and the Council of Mortgage Lenders has warned they will soar to 30,000 next year and then 45,000 in 2008.

The Association of Business Recovery Professionals also recently cautioned that the number of people being forced by creditors into taking out informal debt management plans is rising steadily, belying a recent report which suggested that the number of insolvencies was actually falling.

Whether or not the crunch will have a concomitant effect on wider economic growth and jobs is at this stage anyone's guess, but no serious observers are under any illusions that stubbornly-high interest rates and a drying up of liquid money can be good for the economy.

And while recent reform to US mortgage lending legislation serves as one small glimmer of hope that irresponsible lending and its devastating consequences may be a thing of the past, many will question whether the human vices that gave rise to this situation can ever be fully eradicated from insufferable global money markets.

"Sustained benign economic conditions and previously buoyant market liquidity appear to have fostered complacency among some investors, undermining standards of due diligence," the Bank of England's Financial Stability Review posited. And that means we all got greedy.