Friday 7 December 2007

The Economy in Turmoil - Sub-Prime Mortagages

A lot has happened over the last few months, the sub-prime mortgages fiasco, the banking crisis in Britain, housing prices dropping, the inevitable slowing down of the economy and the recent cuts in interest rates by the MPC (Monetary Policy Committee) and of course rising oil prices.

All of these can be seen to be linked. America, being the worlds biggest economy, affects the world economy by events taking place in its economy. So the Sub-prime mortgage lending that was going on, where basically the banks were giving loans to people with bad credit history, and being extremely lax about it, meant that suddenly, as a lot of loans went bad (people couldn't pay them back) you have major banking firms reporting losses on a gigantic scale, and we are talking billions of dollars. CitiGroup's chief executive and chairman resigned after it was announced that profits for the quarter were down 57%, and their $55 billion Sub-Prime mortgages portfolio has lost between $8-$11 billion dollars in value. And most other banks have been hit drastically too. Goldman Sachs forecast a £200 billions of loss to sub-prime mortgaging to the entire financial sector.

This, combined with the rise in oil-prices, (which are influenced by a number of factors such as time of year, middle-eastern situation, trading on the commodities market and the strength of the dollar) has meant consumer confidence has taken a severe beating. Just look at what happened at Northern Rock...if that wasn't a loss of confidence then what it? Now consumer confidence is very important to all countries but especially so to the US. This following statement is from the BBC and explains the impact of consumer confidence or lack of:

"Consumer spending accounts for two thirds of the US economy. Their lack of confidence and falling house prices have hit analysts' forecasts for economic growth. Capital Economics analyst Paul Ashworth said that the data "supports our view that US GDP will contract over the final three months of this year and that falling house prices will constrain consumption and cause GDP growth to average only 1.7% next year."

And of course the house prices are falling due to the repossession of homes that banks do when people default. This has meant lots of unsold houses which has led to a fall in prices. The following picture shows the situation in a badly struck Cleveland:

Now when America's economy sneezes, the rest of the world seems to get the cold. With the inter-bank trading become much more cautious after this crisis, meant that Northern Rock struggled to get the funds its business required, and hence the run on its branches. And of course the losses were also to some degree shared by the British financial sector.

The British economy has definitely slowed, which isn't a big deal, it was widely forecast to. But the fact it has happened at a time when inflation is slightly high, has meant that the normal way of combating it, by cutting the rates will just mean that inflation gets worse. This is the key reason why stimulating the economy will prove such as difficult task.

As Evan Davis the BBC Economics Editor pointed out that due to the drop in the value of the pound, which is due to the inflation, Britain's exports would become cheaper and drive the economy forward that way. However there are certain problems with that such as the currency value of other countries is cropping too, in fact this is the highest the pound has been to the dollar ever. But hey lets hope.

PS: In my Virtual Trader account (see my review on it in an earlier post) I went on after a long while, what with being in Egypt and things, and imagine my bemusement when I discovered that I had gone and bought shares in Northern Rock which were now gloriously in the red. Goes to show that a thorough look at the figures and an understanding of the business model is the key to buying the right shares. Something I'll keep in mind for next time.






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