Why it's safe to leave eggs in the nest

12:23pm Monday 6th October 2008

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The past few days have seen unprecedented turmoil in world financial markets as banks, fearful of lending to institutions that may go under at any time, desperately hold onto capital.

This “credit crunch” has made stock markets plunge and previously strong companies suddenly go to the wall. Business editor Sam Thomson examines what went wrong and what the ordinary person in the street can do to protect their savings and investments.

In simple terms, the credit crunch is a result of financial institutions across the globe playing a massive game of pass the parcel.

Lenders, desperate to take advantage of seemingly neverending house price rises, dreamt up increasingly diverse ways of giving people the chance to take out a mortgage, even if the chances of them being able to maintain repayments in the long term were remote.

In the US this resulted in an explosion of the “sub-prime" mortgage market, where people on low incomes were tempted by very low repayment rates for the first few years.

Meanwhile, the buy-to-let market in the UK thrived as lenders offered people mortgages many times their salary or allowed them to “self-certify” their incomes without any further checks.

These poor-quality loans were mixed up with good quality mortgages and wrapped up in packages of debt in a process known as securitisation. These debts swirled round and round the financial system and made nice profits for traders, banks and other institutions.

This was fine as long as house prices were rising. If people defaulted and their homes were repossessed then the lender would have an asset worth more than the money owed.

Unfortunately, the only sound heard when the music stopped was the crash of the housing market.

This has left global financial institutions holding massive amounts of debt, some of which is “good” – money lent to solvent, sensible people who make regular repayments – but some of which is very bad indeed.

With no certainty about the level of bad debts held by financial institutions, banks been very unwilling to lend to each other and, in turn, ordinary companies are finding it incredibly difficult to get credit.

High-profile casualties of the crisis include American investment bank Lehman Brothers, Northern Rock and Bradford & Bingley, which have either gone bust or been nationalised.

If the situation carries on, the list will certainly grow. Step forward US Treasury Secretary Hank Paulson with his $700 billion plan – now approved by Congress – to buy up the bad debts and get the credit markets moving again.

Sarah Maguire, chartered financial planner at Haywards Heath-based Lucas Fettes, can understand ordinary people’s frustrations at what looks like a bail-out for greedy bankers but insists that it must happen.

She said: “We are seeing something that is unprecedented in living memory and has come about because of a lack of certainty in the market.

“People have made bad decisions and the taxpayer is going to pay the price. This has to happen even if it doesn’t feel right.”

Although she warned that the crisis will lead to tax rises and job losses, especially in the banking sector, Ms Maguire believes the system will emerge stronger and better regulated.

People should also not be worried about their savings.

Ms Maguire said: “What the Government has been telling us is that it will not allow people to lose money. The long-term issue is how much it will cost us. We will see an increase in taxes because the Government does not have a bottomless pit of money.”

The safest place to put your cash, Ms Maguire said, is in Government-backed National Savings and Investments, information on which is available online or at the post office. In the meantime, patience is a virtue.

Ms Maguire said: “People have short memories and the market will recover. The housing market has been affected but over time it will get better. It is all cyclical. We still have a shortage of houses in the UK.

“Confidence will return and people just need to ride out the storm.”

While most people can take comfort from this message, it is already too late for those who stretched themselves to join the buy-to-let market.

Terry Balfour, of Brighton debt solution site IVA.com, said: “Plummeting property prices and the global financial crisis are having disastrous effects on property market investors at the lower end of the scale.

“We are hearing from people with quite modest incomes who just didn’t have the margins to cope with a downturn in the economy.

“The immediate obvious solution would be to sell up but with the state of the housing market right now that’s easier said than done.”

Mr Balfour said he had seen a huge rise in the number of struggling buy-to-let investors contacting his site, which helps consumers link up with insolvency professionals to manage their debts.

Others feeling the pinch are small investors playing the stock market. In recent days the FTSE 100 has dropped below the 5,000 level, wiping billions of pounds off the value of shares.

But according to Alan Harris, branch manager of the Brighton office of Charles Stanley Stockbrokers, this is no time to panic.

He said: “The sensible thing at the moment is to put money into the big FTSE 100 companies as they are safer. This includes the major banks even though they are having a pretty rocky time.

“The worst is probably over, though, and I just cannot see any of the major banks having to be rescued.”

In times like these it is better to think big. Mr Harris said: “When markets are booming small companies offer a better chance to prosper but in difficult times the opposite is true.

“Smaller business are finding it difficult to borrow and cannot buy their way out of problems.

Look for the well capitalised companies, with low debt and strong balance sheets.”

Anyone wanting to invest should take a three to five year view, he said. “My feeling is that we have seen the worst and we are not that far from the bottom of the market.”