As we hear news that US interest rates have been slashed by three quarters of one percent there are high hopes that we may see similar action in the UK. However, will the Bank of England really see the need to take such action? Is the UK economy as bad as the US economy?

While there is no doubt that we will see further ongoing reductions in UK interest rates over the coming weeks and months, it seem very unlikely at this moment in time that we will see such a knee jerk reactions as that seen in the States. Let’s not forget that the credit crunch began in the US and it is the US housing market which is currently bearing the brunt, with record numbers of home owners on the verge of being evicted, personal debt at record levels and unemployment starting to move upwards.

Only this week we have seen massive billion dollar write-offs by some of America’s largest financial companies, many of whom where left with massive losses on bonds and other financial instruments when the sub-prime credit market collapsed. As yet we have not seen such large write-offs in the UK, but that does not mean that the UK financial sector has remained unscathed, more that loses (all be it smaller) have not yet been quantified.

So why is the UK economy potentially different to the US economy?

While there is, and always has been, a close correlation between the UK and US economies they are not currently at the same levels in the boom and bust cycles. Indeed the UK authorities have managed to reduce the often wild swings between the boom and bust cycles, where perhaps the US authorities have not been as successful. This has resulted in a stronger core UK economy although that said there will be a marked downturn in 2008, with many areas of business already seeing reduced demand.

The UK authorities need to strike a balance between pain for the economy and the consumer against a need to keep the rate of inflation under tight control. However, it looks as thought the government’s core target rate of around 2% will be breached within the next 12 months with the Bank of England suggesting that the rate could climb above 3% during this next phase of the economic cycle.

Either way the UK economy is in much better shape than its US counter-part where further over exuberance on behalf of the financial sector and the consumer has led us into the current situation. The UK consumer has long been a little more reserved that the US consumer, but there is still no doubt that 2008 will be a difficult period all round.

While the US housing market was flying high and everybody was making money, the banks, builders and home owners alike there were no clouds in the sky and everybody was happy.  Since the onset of the sub-prime mortgage collapse we have seen US house prices fall and millions of US citizens put at real risk of being evicted from their homes after falling behind on their mortgage payments.  But why is there no solution yet?

As often happens in America the problem seems to be the ideals of each of the main political parties, with one favouring regulation and the other demanding a solution from the private sector.  While the politicians engage in cheap points scoring and fighting in Congress, literally millions of Americans are looking to pack their bags very soon and move home – only they have no where to go!

Each day that the politician cannot reach agreement sees more people moved out of their homes, more homes going on the market at sub-market prices and more pressure on the economy.  The situation has the potential to push the US into a very steep recession if no help is forth coming very very soon.  The banks know this and the politicians know this but they seem unable to put a package together – even though they have had up to 12 months notice that the situation was getting worse and worse.

Could this happen in the UK?

While you can never say never, the US financial industry has been guilty of pushing high risk loans to those who could ill afford the payments.  Even while the US housing market was flying high, behind the scenes in the sub-prime market, more and more home owners were falling behind with their payments – but was this headline news when the market was rising and rising?

It will be interesting to see how the authorities finally decide to resolve the situation, especially with the presidential election next year.  Who will be brave enough to make the big decisions? How long can they afford to sit on their hands? How will George Bush’s final months be remembered?

In a move which is sure to have epercussions for world stock markets when they reopen on Monday, the Dow Jones was rocked on Friday, falling over 2% after a raft of downbeat announcements.  It  seems that the combined effect of announcements by Caterpillar and Bank of America have brought home the delayed impact which the recent credit crunch will have on the economy.  As we all know, if the US sneezes, the rest of the world catches a cold, so influential are their markets.

So what does this mean in the short term?

In what some may see as a healthy correction, you can expect a fall in world wide markets in the short term and it seems inevitable that interest rates in the UK and US may have to move lower to lessen the impact on economies. 

What happens if the economy slows?

A slowing economy can have a massive effect on employment, investment and the government budgets for public services.  The more people unemployed will reduce the tax intake, which will mean either additional borrowing by the treasury or less money for public services.  The economy is like a large ship which is very hard to steer, and takes a long time to change direction.

The authorities now have an excuse to reduce interest rates, and while there have been reductions overseas, the Bank of England have held steady and not taken any knee jerk decisions so far - which has been applauded by many, but criticised by others.  The next few months will be vital!

While there have been many doom and gloom merchants on the TV and in the media, forecasting massive falls in stock markets, and a slowing of the worldwide economy, we have yet to see any confirmation, but is it on the way? Or has the financial world rode out the dangers of the credit crunch?

On the surface it seems as though worldwide markets are now over the worst, but is this really the case, or is there a storm brewing for the future? Historically we will not see the worst effects of the recent episode until the announcement of company results, with all eyes on the financial sector.  There is no doubt that holes have been blown open in balance sheets, and there is pressure on profitability, but is it really under control?

The price of gold has been rising steadily over the last few months, and is close to an all time high.  Seen by many as a safe haven in times of trouble, it has often moved in the opposite direction to worldwide stock markets.  Will the gold price fall back, or have markets remained a little too resilient after the recent episode? As we mentioned above, the full impact of recent events will not become apparent until company’s release their half year and full year profits, and more importantly forecasts for the immediate future. 

A prominent economic group have recently forecast that up to 6,500 jobs are at risk in the City of London’s financial district - a hangover from the credit crunch.  In the UK it seems as though the economy is set for a period of great turbulence, which was part of the reason why Gordon Brown even contemplated calling a snap election.  While the skies may be clearing, we are not out of the woods yet!

In a sign of the current economic climate and general confusion in the financial sector, it has been announced that the cost of US homes fell by 0.6% in July this year.  The survey took in 10 of the largest US cities in order to give a balanced view, and the results do not make good reading.  Could this be a blessing in disguise, or is it too little too late?

The fact that the US economy is showing definite signs of weakness would normally be a worry, but the fall in the housing market may well stop those who are still over spending.  There has been talk of over exuberance in the US for some time, and while the Federal Bank have done their up most to try and balance the battle against inflation and the need to refrain from over spending, recent events have forced their hand of late.  While the so called credit crunch has been ongoing for some weeks now, there were no definite signs of this in July, so the fall over that period seems to have been as a result of the hike in US rates earlier in the year.

Where will the US economy go from here?

Those who say that the credit crunch is over are sadly mistaken, and there is still more bad news to come out of the sector at some stage.  The sector has been over populated for some time, resulting in some crazy investment decisions by some lenders.  The mortgage sector is set to go through a period of natural culling of certain firms whose business model and lending guidelines have no place in the current environment.  Not only will this reduce the number of players in the market, it will also reduce the competition.

A reduction in competition will reduce the need for firms to look at transactions which are not tenable going forward, which will in time increase the quality of loans, even to the sub prime sector.  No pain no gain as they say, and while the pain has only just started, the long term gains will be very much welcomed!

Recent events in the money markets have shown that once you sign that mortgage / loan deal, do you really know what happens, and where your liability may end up? Unless you have done some major research into the sector, you will probably not be aware about what goes on behind the scenes.  Let us tell you what happens…….

Once you sign that mortgage or loan deal, there is every chance that your agreement could be split up into many pieces and sold to a number of financial companies around the world.  But how is this done?

Simple!

When you sign a financial agreement you will create two separate income streams, interest and capital, which will be stripped and bundled up with a variety of other financial elements.  By bundling many different qualities of income stream into a new financial instrument, it is possible to create a customised vehicle for any requirement.  Risks and the duration of the instrument can be varied simply by taking on different “strips” of any other agreement.

So in effect you take your mortgage out in the UK and within a matter of days your agreement could be scattered to all areas of the world.  This is part of the problem with the ongoing credit crunch in that nobody really knows who is at risk until the pack of cards start to fall, then A cannot pay B who cannot then pay C, and so on.  After a short period of time, liquidity dries up, finical institutions need to retain their funds, and the internal money market is dead.  Step forward Northern Rock for 75% of that last mortgage they agreed, in the form of a commercial loan, but the funding is not there!

While the above description may sound a little simplistic , it really is that simple.  A lack of confidence in the money markets can lead to banks withdrawing their finance from the markets, which results in other companies not being able to function normally, which results in Northern Rock like situations.

Northern rock is a little different than most banks as it borrows a large amount of mortgage funding from the market, rather than being in a position to use its own assets.  The likes of Barclays, Lloyds, etc are total different in that they are more likely to use their own asset to back 75% of a mortgage agreement, and borrow 25% from the money markets. 

After a sustained period of rising interest rates to try and squeeze consumer demand, it looks as though the US Federal Reserve are about to back track on their recent strategy and introduce an interest rate cut to try and stimulate the economy and reduce the effects of the ongoing credit crunch. It is a major shift in policy but one which has been forced on them in reality.  So what next?

If the latest rumours are correct this will be the first reduction in US interest rates for over 12 months, and should mark the top of the interest rate cycle.  While a reduction in interest rates will assist the economy, there are also fears that it would introduce “cheap money” and feed the inflation monster again.  The authorities are in a very difficult situation because if they keep rates high for too long, the economy may stall and fall into recession.  However, if they reduce rates then they may well avert an imminent economic correction, but they would just be storing up problems for the future with a probable boom and bust scenario.

To be fair, the Federal Reserve have been fairly successful with their recent interest rate strategy, and had it not been for low grade mortgage sales by some of the sub prime mortgage providers, the economy would have been slowing at the moment, rather than having the potential to grind to a shuddering halt.

Will events in the US effect the direction of UK interest rates? Yes, so it is probably a good idea to keep an eye on developments in the US market over the days, weeks and months ahead.

The UK credit crunch has now taken hold of its first major UK causality, with Northern Rock forced to call on the Bank of England’s “lender of last resort” system, to bail out their business.  While the situation is only short term, it has caused major upset with the Bank’s customers with over £1 billion of deposits withdrawn over the last couple of days.  So how did Northern Rock get into this mess, and is it terminal?

The problem with the Northern Rock business model is the fact that they lend 75% of all mortgage amounts from the inter bank market - effectively borrowing money from their banking counter-parts.  This has left them more wide open than most to the recent disappearance of commercial lenders, in light of concerns within the US financial markets.  As lenders have disappeared from the market, Northern Rock have been pushed into a corner whereby they have had to call on the Bank of England to allow them to agree future mortgages.  So how much will this cost Northern Rock?

While the loan situation is purely a technical phase, the Bank are being charged an enormous 6.75% by the Bank of England, which will reduce their profit margin on future mortgages.  Last year the group made profits of some £500 million, so you can see from their history that they are not a small bank.  Unfortunately, while the turmoil continues and customers clamour to withdraw their funds from the bank, their reputation is being ruined and when the situation calms down they will almost certainly become part of a larger group, with the  likes of Lloyds TSB being mentioned as a possible suitor.

While many may not have been aware of the internal credit market before the recent downturn, it does demonstrate how events in another part of the world can result in the collapse of confidence, and even businesses, in another area of the world.   The financial markets around the world are so entwined that the knock on effects can last for some time, and have disastrous effects.

Northern Rock may be the first major UK bank to hit trouble, but there are rumours that a whole host of others are finding life tough.  This is not the last of the credit crunch problems in the UK, you can be sure of that!

While we have all heard about the sub-prime crisis in the US and the problems in the credit market, many are asking how and why a problem with the US economy should effect other areas of the world such as the UK.  While it is a very valid point, there are a number of reasons why it actually happens.

In brief, while the US economy is the largest and most powerful of the economies around the world, in effect there is only really one economy - the worldwide economy.  Individual areas such as the US, China, UK, etc have an impact on the worldwide economy to varying degrees, but such is the integration of multi-national companies, the ease with which you can purchase goods and invest overseas,  that basically all economies are connected in some way.

A drop off in the Chinese economy would impact upon demand for US goods and US services, which would then impact on the US economy where companies may have to cut costs, thereby impacting on the property market as more people find it difficult to find full time employment.  These are the types of connections which are now common place.

The financial sector is one of the purest forms of a worldwide market, with for example mortgages secured in the US probably sold on throughout the world as parts of more complicated financial instruments.  This has been one of the reasons why the credit crunch in the US has actually overlapped into areas such as the UK, etc, where many UK institutions have taken on exposure to the US mortgage market - with potentially billions of pounds at stake!

As worldwide economies become more and more entwined, the chance of knock on effects becomes even greater - something which we are seeing more and more of.   

In a move which was expected, but is set to be the first of many from the main mortgage providers, Northern Rock have today announced an increase of 1.25% in their sub-prime mortgage rate.  This on the same day that US house sales fell to a five year low, is a reflection of the current market turmoil - something which is far from over.

While there had been concerns that Northern Rock were at risk from the sub-prime mortgage turmoil, they have announced that their more risky mortgages are managed by broking giant Lehman Brothers, for a set fee.  This effectively covers the former Building Society from any major fall-out in the market, and allowed many investors to breath a huge sign of relief.

Even though Northern Rock seem to have protected themselves, the same cannot be said of Barlcays who are rumoured to have some major exposure to the troubled sector.  The departure of one of Barclays Capital’s major deal makers last week has added further fuel to the fire.  Until they (and other banks) come out and confirm their exposure, the rumours will continue and grow in strength.

The financial sector is currently under a cloud, and until the situation is resolved there seems little likelihood of any sunshine!