What crisis?

11:48am Wednesday 16th April 2008

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Don't know your sub-prime mortgage crisis from your credit crunch? And what was Northern Rock all about?

As the Royal Institution of Chartered Surveyors reveal house prices are falling at the fastest rate since 1978, Owen Amos presents the Idiot's Guide to Recession

What is recession?

A recession is a fall in a country's Gross Domestic Product for two consecutive quarters. The UK's GDP has grown every quarter since 1992. In the last quarter of 2007, growth was 0.6 per cent.

However, there hasn't been growth of one per cent or more in a quarter since 2003.

Is there a recession coming?

Investment bank Lehman Brothers says the UK has a one in three chance of recession in the next two years. The Royal Bank of Scotland says there is a 15-20 per cent chance.

Why is economic growth slowing?

A number of reasons, many interlinked, including: record oil prices, the sub-prime mortgage crisis, the credit crunch, and the stock market downturn.

What are sub-prime mortgages?

A sub-prime mortgage has a higher-than-normal interest rate and is taken by people with poor credit histories who are denied normal mortgages. They are especially popular in the US.

Some called them Ninja Mortgages - taken by people with no income, no job and no assets. By 2005, one in five US mortgages were sub-prime. It helped increase US home ownership from 64 per cent in 1996 to 70 per cent in 2004.

So what's the problem?

Banks sell these mortgages to third-party bonds.

This means banks can raise more money and offer more mortgages. However, it also means fewer checks were made on mortgage customers.

By 2006, the high-interest, sub-prime mortgages became too expensive for many. Banks, and the third-party bonds, stopped getting paid. In 2007, for example, HSBC announced it lost £5.4bn in the sub-prime mortgage market.

Those mortgage holders who couldn't pay had their homes repossessed. This caused US consumer spending to fall, which, as the largest market in the world, caused problems for every country that exports there. To counter this, in January the US Congress passed a $150bn package which means tax rebates from $300 to $1200 for millions of Americans.

What is the credit crunch?

Banks, such as HSBC, and third-party bonds - often hedge fund investors - lost vast sums in the sub-prime crisis. This means they have less money to lend, fewer companies and people have been able to borrow money and this means they spend less - causing the economy to slow down.

Did that affect Northern Rock?

Northern Rock, like other banks, raised money from other banks. Therefore, the credit crunch made it vulnerable. Lenders were particularly wary of Northern Rock, as it is a mortgage specialist. In the current climate, lenders were worried the Rock would not get its money back.

Therefore, it had to borrow £3bn from the Bank of England as a "lender of last resort".

How does the credit crunch affect my mortgage?

There is less money around. Therefore, what there is becomes more valuable. This means mortgage rates are increasing - particularly worrying for those approaching the end of a fixed-rate deal. Analysts recommend paying off as much of your mortgage as possible.

What about house prices?

The average UK house price has risen 171 per cent since 1998 - from £70,696 to £191,556. However, for the first time in that decade, credit - and therefore mortgages - are hard to get. So there are fewer people able to buy houses. As demand decreases, but supply stays the same, prices will fall to attract buyers. In March, for example, house prices fell by 2.5 per cent from February, according to Halifax. Nationwide figures show house prices have fallen in each of the past five months. However, the North-East is one of the few areas where house prices have risen slightly.

What if I'm a first-time buyer?

You're in trouble. The credit crunch means banks have less money available. That means they are far less keen to lend money - especially to "high risk" customers, such as first-time buyers. For example, the era of the 100 percent mortgage - that is, a loan that covers the total house price - is over. A year ago, there were 158 on the market.

Now, there are none. Some lenders offer 95 per cent mortgages, but most require at least a ten per cent deposit. So, with the average house price of £190,000, first-time buyers need a £19,000 deposit before they can buy. However, there is good news - house prices have stopped rising for the first time in years.

What about oil prices?

Oil was $25 a barrel in September 2003. It is now $112 a barrel. In the past year alone, the price has increased by 91 per cent. There are a number of reasons for this. Firstly, the supply has slowed down. With finite supplies, easy-to-access crude oil is increasingly hard to find. The war has caused supply to drop in Iraq, there have been strikes in Venezuela and unrest in West Africa.

Also, OPEC - the Organisation of Petroleum Exporting Countries, which exports around half the world's oil - deliberately limit production to keep prices high. Though production has increased, commentators say they should do far more.

Decreased supply has been exacerbated by increased demand. In China, for example, oil consumption is growing at 15 per cent per year.

Worldwide, demand will rise by 2.2 million barrels a day next year, the International Energy Agency says. More people fighting over fewer resources: price hikes are inevitable.

How does that affect our economy?

The price of oil affects, more or less, the price of everything. Filling your car, for example, may cost £40 a week compared to £30 last year. This means £10 less to spend elsewhere - causing the economy to slow. But it doesn't just affect you.

Higher petrol prices mean higher haulage prices - meaning prices in shops are higher. Heating and electric prices increase. Other things made from oil include plastic, nylon and paint. When oil prices increase, so does the price of those goods.

What can the Government do?

The Government is desperate to avoid a recession. To do that, it must increase consumer spending. To do that, it must try to give people more money, so it has cut interest rates from 5.75 per cent in 2007, to five per cent now. This has two effects. Firstly, saving becomes less profitable, encouraging people to spend. Secondly, cutting the base interest rate encourages lenders to lower their rates - making loans and mortgages cheaper. Although not mandatory, Halifax, Nationwide, Woolwich and Cheltenham & Gloucester all passed on the recent cut to customers. Another macro-economic tool the Government could use - as the US government did - is significant tax cuts. Don't hold your breath.