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Originally published on author's site on August 26

Over the last few months, we've talked extensively about the UK economic outlook, even offering two ways to profit from the coming downfall.

On March 29, we recommended buying the September 2008 CurrencyShares British Pound Sterling Trust 200 put [FXBUR] around $5. Today, it's a sell at or near its current price of $13.50 - a gain of 170% in just months.

At the time, even George Soros was reportedly short the pound again.

Then, on June 10 we recommended buying the iShares MSCI United Kingdom Index ETF (EWU) to play further UK downside. Had you bought the October 23 put [EWUVG], for example, around $1.90, you're up about 111% in just months.

And if you're interested in similar gains like those above, check out our newest and most aggressive options service, Options Trading Pit.

But I digress...

Who didn't see the UK economy crumbling?

The UK boasted an annual GDP growth rate of 2.5% for years, with some calling for 3% growth in 2007. But that was before the credit crunch, a crippling housing market, and a cutback in consumer spending. Worrisome, UK consumers depend more on credit that US consumers do, drowning the economic view of the UK economy into the River Thames.

It was November 2007 when the Bank of England's chief economist warned that the effect of the credit crunch on banks may only be the tip of the iceberg.

But who didn't see this coming?

In the early days of February 2007, we saw the beginnings of a sub-prime meltdown that would soon wreck the future of housing, easy credit, and people who bought homes they couldn't afford. Now, months later, homebuilders and lenders are knee-deep in debt. And there's no real chance for a housing turnaround until 2010, at the earliest.

The UK Housing Crisis

But just as the U.S. has struggled for some control over sub-prime, Britain had to get aggressive or risk a tumultuous economic future. In the UK, more than 90% of all mortgages are adjustable-rate or floating-rate mortgages. More than 1.5 million homeowners are considered sub-prime, and another four million are seen as high risk because of imperfect credit histories.

And, as we've seen in the U.S., the ARM resets are having a negative effect on British consumers, sending the housing market into a U.S.-type tailspin.

Is it any surprise that UK banks felt the pressure, too? They wrote off more than $18 billion in bad consumer debt last year alone. It was the sole reason I shorted shares of Northern Rock [NRK.L] at about 700, to watch it crash and burn under 120.

And there's still the fallout from falling home prices, and rising mortgage payments. The UK Financial Services Authority, for instance, says (as reported by the Wall Street Journal), "homeowners, whose monthly mortgage payments are resetting this year could face an increase of $411, at a time when they are already digesting a sharp rise in energy and food costs."

But behind the scenes the availability of cheap debt was coming back to haunt the UK.

These days, the Bank of England is reporting that mortgage applications have fallen about 50% over the last year to levels not seen since the early 1990s.

Even the Halifax house price index recently fell more than 6%. And house price declines like this only happen when the economy is in recession and unemployment is rising.

The other reason for house price declines is when there's a loss of monetary policy control. And that's happening as a result of the credit crunch, which has lessened the availability of credit.

Outlook on the UK Economy: This Recession's Only Getting Worse...

With rising interest rates, and the value of homes declining, more UK homeowners who had little capital to begin with are finding themselves in hot water. Now that the bubble has burst, a reported 37,740 UK homeowners, between March and June 2008, according to Spiegel.de, lost their homes to the bank.

Worse, UK home prices posted the biggest yearly decline since 2002, as banks cut off mortgage lending, deepening the crisis. The average selling prices fell close to 5 percent in August, year over year.

And now there are worries of a technical recession, according to a Bank of England forecast. "It is bound to be the case there will be a quarter or two of negative growth," reported the Bank in its outlook.

But while interest rates should be cut to counter recessionary risk, doing so plunges consumers deeper into inflation. Consumers are already struggling with higher food, mortgage and energy costs, just as we are in the U.S. In the UK, inflation has hit 4.4% and is on the rise.

That's on top of news that jobless totals could rise another 300,000 to more than two million.

Even the IMF is delivering a "grim" outlook for the UK, cutting growth forecasts to 1.4% in 2008 from the 1.8% predicted in May, and warning the UK Prime Minister that the budget deficit needs to be controlled.

So How Do You Profit from the UK Economic Downfall?

You buy long dated puts on the pound and the British ETF... and sit tight for the next few months.

A year ago, no one thought it would come to this. Northern Rock and Bradford & Bingley were sailing along nicely, packing mortgages. The Treasury and the Bank of England had no reason to be concerned. Consumers were happy. The economy was growing well, and the Bank was raising rates to slow things down. Now... well, as Bob Dylan sang, "The Times They Are A-Changin."

Disclosure: None

Source: U.K. Economy on a Tight Rope: How to Profit