Weather the stock market storms

It won't just be City bonuses that end up hammered by rollercoaster markets. The rest of us may pay a high price too through more expensive mortgages, dearer credit cards and renewed pain for pensions.

So how did it happen, and how can we survive the crisis? Scotland on Sunday has produced a layman's guide that takes you step-by-step through what has caused the tumult and tells you how to protect your finances.

What started the crisis?

Higher interest rates in the US triggered a crisis in the sub-prime mortgage market, which lends to vulnerable borrowers at anything up to twice the rate paid by other customers. Such loans are often aggressively sold by doorstep lenders without any proper credit or salary checks.

A hunger for such investments by big pension and hedge funds, because if sold properly they provide a guaranteed income stream, saw the market in the US mushroom to $2 trillion, accounting for a fifth of all homebuyers. Evidence is mounting that many of these loans were not simply poorly sold, but fraudulently sold with potentially catastrophic consequences.

Half of the 25 biggest sub-prime lenders are now teetering on the brink and arrears are running at 13%. In the final three months of 2006, repossession proceedings were instigated against one in 200 homebuyers throughout the US, with sub-prime borrowers hit heaviest.

Why is this affecting the UK?

To raise more money, US sub-prime lenders bundled up their mortgages and sold them on to other institutions and funds, primarily hedge funds. Not only do many hedge funds hold large parcels of now worthless mortgages, they can be carrying four times as much borrowing as they have assets. To shore up their own positions, many are now dumping what stock they do possess, pushing markets down further.

The biggest threat is that should hedge funds collapse, this would reap havoc on their owners, including major UK, European and US institutions.

However, right now we do not know how significant such a threat might be. So secretive are many of these funds and the way they work, that even their owners are not clear what their liability might be or which debts they may be responsible for.

Stock markets hate uncertainty, hence their continued jitters. Banks are also increasingly nervous, and are reluctant to lend, even to each other, leading to a credit crunch.

What is a credit crunch?

Essentially, banks become much fussier about who they lend to and take a dimmer view about the likelihood of getting their money back. So where they will lend, they charge more to cover their risk. This can have serious consequences for mortgages, credit cards and overdrafts.

But the pain will not end there. Businesses too face higher borrowing costs, which can push up prices and dull sales.

Combined, all this can push the economy into a retail recession and lead to job losses.

The new jokers in the pack are private equity companies. These are funds which borrowed heavily to take over firms such as the AA and Saga. The jobs of millions of UK employees now depend on these funds. However, their costs will rise along with interest rates, making improved profitability harder to achieve.

Furthermore, the squeeze on borrowing will make such deals more difficult to pull off in the future, calling a halt to the mergers and acquisitions boom which has been driving share prices higher.

It should also signal an end to big City bonuses, dampening property prices in some hotspots, particularly in London.

Will my mortgage go up?

Yes and no. The Bank of England had indicated one more quarter-point increase in borrowing costs before next September, pushing up the monthly price of a 100,000 mortgage by 16.49. If this happens, borrowers will have been stung by an extra 125 monthly since a year ago.

The Bank had made it clear it expected this new pain to begin in September. However, the move by the Fed to cut the discount rate on Friday makes this look much less likely. If the markets continue to reel, the next step will be a cut in consumer borrowing costs in the US, triggering lower rates elsewhere.

But as banks batten down the hatches, they will also look to widen their own profit margins against the perceived increased risk of default. This will make loans more difficult to come by. Alternatively, they may wish to lower their exposure to bad risks by demanding bigger deposits, which will cause problems for property buyers.

And it is not just young housebuyers who will be hit. Norwich Union has increased interest by 0.5% on its lifetime mortgages, making it more expensive for pensioners to use their homes to buy an income.

The only silver lining was a slight fall in fixed-rate deals as the threat of an immediate rate rise has receded. Experts believe that lenders will continue to offer competitive deals, but these may be more limited and harder to come by.

What about credit card debts?

Similarly, banks will wish to protect themselves against bad credit cards debts, so may be less generous with their credit.

Expect to see credit limits being squeezed. It will become more difficult to switch debt around between lenders, and if you do fall behind, the banks are likely to move more swiftly to recover their money.

The same Draconian approach is likely to apply to overdrafts.

Is this good news for savers?

It should be. If the days of cheap money are over, then savers should be in for higher returns.

The credit crunch may also work in savers' favour because if banks and building societies cannot raise funds on the wholesale money markets so easily and cheaply, they will have to woo the small saver again.

Look out for some headline-grabbing returns.

What about my pension?

Sliding stock markets can be catastrophic for anyone approaching retirement, although most pre-retirees should have been advised to switch into cash in the years before picking up the gold watch. Otherwise, pension planning is a long-term business, capable of riding out market swings, so don't panic.

However, if the era of cheap money is over, higher interest rates will make annuities cheaper to buy.

Should I buy my annuity now?

Annuity rates have not moved during the recent storms, but could improve when markets steady. For this reason some commentators are suggesting those approaching retirement should hold off for a bit.

However, even if higher interest rates are good for retirees, annuities are still threatened by the impact of the latest data on longevity from the actuarial profession (see Wealth Watch column opposite).

Annuity Direct's Stuart Bayliss believes the optimum time to buy an annuity will be this November or December.