Britain's biggest mortgage lender, HBOS, gets into such hot water that it is taken over by a smaller bank, one of the big five investment banks in the USA, Lehman brothers, goes bust, stock markets around the world plunge, inflation rises again and the Bank of England's Monetary policy Committee decides almost unanimously (only one out of nine voted for a cut) to keep interest rates on hold.

The last seven days or so have seen some dramatic events in the market.  But do they really matter and are things as bad as they seem, at least as far as the average homeowner is concerned?

Inflation and interest rates - on the way down

It is just possible that things are not as bad as the headlines suggest.  Take inflation and the Bank of England's decision to hold base rates at 5.0 per cent this month.  With CPI inflation rising from 4.4 per cent to 4.7 per cent in a month, it's hardly a surprise that the MPC felt they couldn't cut rates now. 

But it seems very likely that inflation will start to fall soon.  Oil prices are down from a mid-summer peak of $147 to around $95 today.  Other commodity prices have fallen with it.  And it is interesting to note that, while CPI inflation - the official measure - rose in August, RPI inflation fell from 5.0 per cent in July to 4.8 per cent.  The fall was largely driven by cuts in the cost of mortgages which are not included in the CPI figures. 

Admittedly, the fall in the value of the pound will make imports more expensive, but lower oil and raw materials combined with weaker consumer demand will push inflation down.  When that happens, the Bank should cut rates.  That, in turn, should make mortgages cheaper, helping homeowners struggling with higher food and energy costs to manage their mortgage payments.

HBOS merger - lending could rise

Then what about the take over of HBOS, Britain's largest mortgage lender, by Lloyds TSB?  With only the bare bones of the deal in the public domain, it's hard to know for certain what impact the deal will have.  But the chances are that the real losers will be the shareholders.  Anyone who bought HBOS shares for more than £2.32 will face a loss on their holding. 

For borrowers, the question is whether the combined Lloyds TSB/HBOS group will lend less in mortgages than they did as separate banks.  If total mortgage lending falls, then that would have an impact on the property market.  Lloyds TSB, however, says that new lending by the new combined bank will continue at least at current levels and will expand as market conditions improve.  In fact, if the merger leaves the combined bank stronger, it is possible that it will be better placed to increase lending than either of the two banks would have been on their own.

Short selling on hold

There may also be another silver lining to this shotgun marriage.  There have been persistent rumours that the share price of HBOS was pushed down by what are know as 'short sellers'.  If so, some of them are likely to have had their fingers burnt by the Lloyds TSB takeover.

Short sellers make their money by ‘borrowing' shares in a company, selling them to prompt a fall in the price and then buying them back at less than they sold them for.  They return the shares to their original owner and pocket the difference between what they sold them for and what they paid to buy them back. That's how you make money on falling share prices.

But how do they push down the price of the shares to below the level they sold them at?  Here, the dark arts of the short seller come in to play.

In the case of HBOS, the suggestion was that the bank would not be able to borrow the money it needs from the financial markets. Why does it have to borrow?  When it comes to mortgages, HBOS lends long term to you and me, but it borrows the money to lend us over relatively short periods. When the money it has borrowed is due for repayment, it goes out and borrows it from someone else or the same lender, but possibly at a different rate.  If lenders won't provide the funds it needs, it can't repay the original loan and goes bust.  This is effectively what happened to Northern Rock.

If short sellers could persuade the market that HBOS couldn't raise new funds, the share price would plunge. And so it proved to be. But the rescue by Lloyds TSB might have cost some short sellers dearly, making it difficult for them to buy HBOS shares for less than they sold them for.  If so, they might think twice before trying the same trick on another bank.

And if the prospects of a loss were not bad enough, the Financial Services Authority stepped in last Thursday to ban any short selling of shares in financial institutions between now and January 16th next year. Worse still from the short sellers point of view, they have to declare what stocks they are holding - telling the rest of the world which stocks they want to sell fall. The expectation is that the markets will be a lot more stable with short selling of bank shares out of the way.

US Cavalry?

Perhaps the most important events of the last few days, however, happened on the other side of the Atlantic.  The collapse of Lehman Brothers and the near demise of insurance group AIG were dramatic enough, but they were trumped by the announcements on Friday by the US Federal Reserve, the US Treasury Secretary Hank Paulson and others that the American government was ready to take concerted action, including new legislation, to prevent a financial meltdown.

Lehman and AIG

The collapse of Lehman Brothers had sent shock waves through the financial markets.  Banks around the world owed money by Lehman's may not get all of it back, making it more difficult for them to lend.  Mortgages owned by Lehman's might have to be sold in a ‘fire sale' to repay creditors, pushing down the value of all mortgage backed assets.  If that happened, every other bank holding similar assets would have to revalue them downwards, exacerbating losses and forcing banks to cut lending or to raise new cash - which could be hard to find.

The fall of AIG, however, would have been far worse for the markets and for homeowners.  Among other things, AIG insures mortgages against default.  Investors can buy mortgages safe in the knowledge that the value is guaranteed by what was then world's largest insurance company.  But if AIG went bust, those guarantees would evaporate and investors around the world would have to discount the value of the mortgages they hold.  Once again, banks would have to cut lending and raise cash, probably on a huge scale.  No wonder then that the US government stepped in with $75 billion to buy 80 per cent of the company. 

US authorities step in

The strain on the financial system was enough to make the US government think again about the credit crunch in a new way.  Rather than propping up some banks and letting others fail on a case by case basis, it seems that the authorities in America have recognised that the financial markets need a combination of support together with radical and wide ranging reforms. 

What those will be no-one knows yet - discussions were due to take place throughout last weekend. There are rumours that the government may take over the mortgages that are most worrying the financial markets.  Treasury Secretary, Hank Paulson, told reporters; "We talked about a comprehensive approach that will require legislation to deal with illiquid assets on financial institutions' balance sheets". But the realisation that the powers that be, Congress, the Federal Reserve and the US Treasury, are ready to deal with the issue in a concerted way sent stock markets around the world soaring.  Perhaps Lehman's and AIG was the shock needed to prompt serious and effective action.