Your credit crunch questions answered

Mar 18 2008 By Andrew Mernin

The sell-off of US bank Bear Stearns has no doubt evoked memories of Northern Rock's plunge into crisis last autumn and has even led one economist to describe the sale as nothing more than nationalisation of the bank.

The fall-out from the American banking crisis caused the FTSE 100 Index to plummet more than 2%. But what was the catalyst to spark the global economic crisis and how will trouble across the pond affect us?

Here we answer your questions on the credit crunch:

Q: What has sparked the latest sell-off?

A: US investment bank Bear Stearns yesterday became the latest victim of the credit crunch when it was bought by rival JP Morgan Chase for a cut-price 236.2 million US dollars (£116.4m) after being forced to seek emergency funding on Friday.

Meanwhile, the US Federal Reserve, in a rare Sunday meeting, cut its lending rate to banks to 3.25% from 3.5% and created another short-term loan facility for big investment banks in a bid to ease the pressure.

Far from reassuring markets, the move is seen as further evidence that the financial crisis is deepening,

Q: What caused the credit crunch in the first place?

A: The credit crunch was sparked by high levels of defaults on sub-prime mortgages, for people with poor credit histories, in the United States.

Banks package up mortgages and sell them on to investors in a process known as securitisation. The high level of defaults in the US has left investors with heavy losses, making them reluctant to take on mortgage-backed securities. As a result, the credit markets have dried up as financial institutions do not want to lend to each other and lenders are finding it harder to get mortgage debt off their balance sheets.

Q: What impact will yesterday’s events have on mortgages?

A: While today’s events will not have a direct impact on mortgages, they are likely to exacerbate the trends that are being seen.

The credit crunch has led to lenders becoming increasingly risk-averse. As a result, many products are being withdraw, with no lenders now offering 125% loans and only a handful offering 100% ones. Mortgage lenders are also demanding higher deposits from borrowers in order to qualify for their best rates.

At the same time it has become more expensive for lenders to borrow funds themselves and this cost increase is being passed on to borrowers, with many firms increasing the tracker rates they offer to new customers outside of movements to the Bank of England base rate.

The Council of Mortgage Lenders predicted at the beginning of the year that lenders would be unable to meet about a third of the demand for mortgages due to the problems they faced raising money.

Q: What should I do if I need to remortgage?

A: People who need to remortgage are being advised to start the process at least three months before their current deal expires. The mortgage landscape is very different now to what it was two years ago when many people last remortgaged, while interest rates are also considerably higher.

Once people find a deal they should act fast to secure it with the lender, as huge demand for competitive rates is causing them to be pulled quickly as lenders struggle to keep up with processing applications, while the ongoing funding difficulties they face mean rates for new deals are begin regularly increased, while firms also keep tightening their lending criteria.

Q: What is likely to happen to interest rates now?

A: The Bank of England is widely expected to cut interest rates at least twice more this year to 4.75%, while some commentators claim they could end the year as low as 4.25%.

The Monetary Policy Committee faces a tough job balancing cuts in the official cost of borrowing with its 2% inflation target and it is unlikely to make the dramatic interest rate reductions seen in the US.

Q: I have money invested in shares. Should I cash in my investments?

A: No. Selling shares now will only crystallise the losses. Shares should be seen as long-term investments and some volatility in prices is to be expected. Investors should sit tight and ride out the current falls.

Q: Pensions are heavily invested in equities. Does this mean deficits are going to get worse?

A: In the short-term the funding shortfalls faced by the UK’s defined benefit pensions will increase. But pension schemes invest for the long term and many schemes have also taken steps to reduce their exposure to equities, so the recent stock market falls are unlikely to have a major impact on either firms’ ability to pay pensions or the type of schemes they offer.