The Collapse Begins

By mid-2007, it was clear that the housing market had fallen into real distress. The most obvious sign, illustrated in Figure 3.22, was a long, steep plunge in home prices, as chronicled by the two S&P/Case-Shiller home price indexes.

Falling prices unleashed a cascade of consequences. Many homeowners—especially those who bought near the end of the boom—now found themselves under water (owing more than their home's current market value). Without equity, borrowers with ARMs were unable to refinance before their rates reset. Faced with higher monthly payments, many households fell into default. Foreclosures rose sharply—in fact, RealtyTrac reported that more than 573,000 properties nationwide were in some stage of foreclosure in the first half of 2007.8 Multiple subprime lenders filed for bankruptcy.

Figure 3.22 2005: The Collapse in Home Prices Begins (Quarterly, Q1 1988-Q2 2008) Home price indexes, percentage change on a year earlier 24 -

18126 -0-6 --12 -182007 Subprime Crash

1988 1992 1996 2000 2004 2008

Sources: S&P/Case-Shiller, Office of Federal Housing Enterprise Oversight (OFHEO), Moody's Economy.com, Milken Institute.

In August 2007, the problems reached a crescendo with the collapse of two Bear Stearns hedge funds that invested heavily in subprime-related securities. Many investors grew increasingly concerned about declining asset values and excessive leverage at other financial firms. Moreover, money markets were freezing up; the interbank lending market was charging loan rates at spreads reaching 21-year highs over Treasury securities; and the flight to safety pushed the Treasury rate to its lowest daily level since 1952. Suddenly, the crisis on Main Street had arrived on Wall Street's doorstep. As the timeline in Figure 3.23 illustrates, a torrent of events unfolded in rapid succession as the Dow Jones U.S. Financial Index continued its downward trend.

The credit crunch was on: Figure 3.24 shows that the spread between LIBOR (the London Interbank Offered Rate, reflecting what banks charge for short-term lending to other banks) and the overnight index swap rate jumped from less than 14 basis points in July 2007 to 48 basis points in the second week of August and still higher to 364 points on October 10, 2008. Since August 2007, the average spread was 89 basis

Figure 3.23 Timeline for the Subprime Mortgage Market Meltdown and Credit Market Freeze (December 2006-0ctober 31, 2008) Dow Jones U.S. Financial Index

Feburaiy-March 2007: More than 25 subprime lenders declare bankruptcy.

  1. 2006: Ownit Mortgage, a subprime lender, files for bankruptcy.
  2. 2007: HSBC sets aside $10.6 billion for bad loans, including subprime.
  3. 6, 2007: American Home Mortgage files for

Oct 24, 2007: Merrill announces $7.9 billion in subprime writedowns, surpassing Citi's $6.5 billion.

  1. 11, 2008: Fed offers troubled banks as much as $200 billion in loans; Fed introduces Term
  2. 16, 2008: JPMorgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility.
  3. 17, 2007: Fed cuts discount rate to 5.75% ; Fed introduces Term Discount Window Program.
  4. 13, 2008: President Bush introduces tax rebate stimulus program of $168 billion.

Oct 3, 2008: President Bush signs Emergency Economic Stabilization Act, authorizing bailout of $700 billion. Also, Citigroup sues after Wachovia agrees to buyout by Wells Fargo.

Figure 3.23 Timeline for the Subprime Mortgage Market Meltdown and Credit Market Freeze (December 2006-0ctober 31, 2008) Dow Jones U.S. Financial Index

  1. 6, 2007: American Home Mortgage files for
  2. 16, 2008: JPMorgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility.
2007 2008 Dow Jones High

Oct 27, 2008: Dow Jones U.S. Financial Index=230

' Oct 31, 2008: Dow Jones U.S. Financial Index=269

  1. 2007: HSBC sets aside $10.6 billion for bad loans, including subprime.
  2. 17, 2007: Fed cuts discount rate to 5.75% ; Fed introduces Term Discount Window Program.
  3. 13, 2008: President Bush introduces tax rebate stimulus program of $168 billion.
  4. 14, 2008:1 Lehman files for bankruptcy.

Oct 27, 2008: Dow Jones U.S. Financial Index=230

' Oct 31, 2008: Dow Jones U.S. Financial Index=269

12/2006 02/2007 04/2007 06/2007 08/2007 10/2007 12/2007 02/2008 04/2008 06/2008 08/2008 10/2008

Sources: Datastream, Milken Institute.

Figure 3.24 Liquidity Freeze: Spread between Three-Month LIBOR and

Overnight Index Swap Rates (Weekly, 2001-0ctober 31, 2008)

Basis points

October 10, 2008: 364 bps

350 - 9/16/2008: Fed rescues AIG for $85 billion.-► I

9/14/2008: Lehman files for bankruptcy. -» I

300 - 9/30/2007: NetBank goes bankrupt. II

8/16/2007: Countrywide takes an emergencyAverage since loan of$11 billion from a group of banks.August 2°°7:

150 -89 bps

Average since December 2001: 25 bps

7/31/2007: Two Bear Stearns hedge funds file for bankruptcy. ■

2002 2003 2004 2005 2006 2007 2008

Sources: Bloomberg, Milken Institute.

points, compared to an average of 25 basis points from December 2001 to October 10, 2008.

The TED spread (the gap between the three-month LIBOR rate and the three-month Treasury bill rate; "T" for Treasury bill rate and "ED" for Eurodollars) is another measure of liquidity, reflecting the extent to which banks are willing to lend to one another; a widening TED spread indicates an increased risk of credit defaults in the marketplace. As Figure 3.25 shows, this indicator stood at an average of 86 basis points over the period from December 2005 to October 15, 2008, but on August 20, 2007, it jumped to 240 basis points. It widened still further to 464 basis points on October 10, 2008. The previous high was 255 basis points in November 1987.

In addition, the market for commercial paper (short-term debt, routinely issued by corporations to cover operating expenses) was showing signs of stress. Figure 3.26 shows that the rate firms have to pay on asset-backed commercial paper rose sharply in early September 2007 and then again in December 2007 as compared to the rates paid on comparable rated financial and nonfinancial commercial paper.

Clearly, the meltdown of the mortgage market had produced a widespread shortage of liquidity in the financial system. Firms with

October 10, 2008: 364 bps,

9/16/2008: Fed rescues AIG for $85 billion.-

9/14/2008: Lehman files for bankruptcy. -

9/30/2007: NetBank goes bankrupt.

8/16/2007: Countrywide takes an emergency loan of$11 billion from a group of banks.

Average since December 2001: 25 bps

7/31/2007: Two Bear Stearns hedge funds file for bankruptcy.

Average since August 2007: 89 bps

Figure 3.25 Widening TED Spread: Spread between Three-Month LIBOR and T-Bill Rates (Daily, December 31, 2005-October 31, 2008)

Basis points 500

12/2005 04/2006 08/2006 12/2006 04/2007 08/2007 12/2007 04/2008 08/2008

Sources: Bloomberg, Milken Institute.

Note: The TED spread is calculated as the difference between the three-month LIBOR and three-month T-bill interest rate.

Figure 3.25 Widening TED Spread: Spread between Three-Month LIBOR and T-Bill Rates (Daily, December 31, 2005-October 31, 2008)

Figure 3.26 Market for Liquidity Freezes (Daily, May 1, 2007-0ctober 31, 2008)

Thirty-day AA-rated commercial paper rates, percentages

September 5, 2007: 6.34%

6 December 12, 2007: 6.17% September 30, 2008: 6.05%

Asset-backed /

commercial paper

Financial commercial paper

5/1/2007 7/25/2007 10/18/2007 1/10/2008

Sources: Federal Reserve, Milken Institute.

Financial commercial paper

Non-financial commercial paper

4/3/2008

6/26/2008

9/18/2008

cash were holding onto it, and other firms were rebuilding their capital, making them reluctant to lend.

These multifaceted problems soon spilled over to the real economy. Even beyond the financial sector, credit spreads widened and stock prices declined. The unemployment rate rose as recessionary effects set in. Efforts to help the credit markets toward recovery became critical.

Overwhelming uncertainty in the marketplace bracketed these problems: uncertainty about the value of assets ultimately collateralized by homes and, therefore, uncertainty about the financial condition of the firms holding or guaranteeing these assets. And looming over it all was worry over the murkiness hidden in the form of outstanding credit default swaps, which had grown to enormous sums and could be triggered if the markets worsened and the underlying securities fell in value. Little information was available about the counterparties to these credit derivatives and their exact risk exposures and financial conditions.

Meanwhile, home prices now seemed to be in freefall. As Figure 3.27 shows, home prices had fallen a few times before October 2005 but had never plunged so abruptly and so deeply as they did after that month. In August 2008, the median home price had fallen 9.8 percent from the previous year. The declines were even steeper in once-overheated regions.

Figure 3.27 Median Existing Home Price: Too Good to Last (Monthly, 1969-August 2008)

Percentage change, year ago 25 -

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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Responses

  • Jole
    Why subprime spread widened in april 2012?
    7 years ago

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