The foundation of a systemic financial crisis was in place by early 2007. The securitization frenzy had been in full swing for several years, pumping out trillions of dollars in debt backed by increasingly shaky mortgages. Excessive lending was fueling both homebuilding and buying, pushing prices to levels that made single-family housing unaffordable to more and more families. The market was increasingly dominated by speculators.
A type of euphoria had taken hold. After several decades of almost continual economic growth, punctuated by only brief and shallow recessions, many believed the business cycle had been tamed. Globalization, sophisticated financial markets, and expertly managed monetary policy meant any financial crises and recessions would be mild and short-lived. Some dubbed this new era the Great Moderation.
Such thinking empowered more risk-taking, not just in the mortgage and housing markets but throughout the financial system. Credit spreads—the difference between interest rates on riskier bonds and on risk-free Treasury securities—narrowed dramatically as investors bought risky assets with increasing abandon. Representative of this was the extraordinarily thin 2.5 percentage-point gap between the interest rate on lower rated or “junk” corporate bonds and that on 10-year Treasuries (see Figure 1.5). In normal times, this spread would be closer to 5 percentage points. During the financial panic it was more than 20 percentage points.
Figure 1.5. High-yield corporate bond spread to 10-year Treasuries, basis points.
Sources: Federal Reserve, Bloomberg, Moody’s Analytics
The euphoria held the seeds of its own destruction. Investors had become overextended in every direction, and increasingly confused by the dizzying complexity of the things they were blindly investing in. Securities were broken into pieces or tranches, each holding a different amount of risk. Tranches of different securities were packaged together to form collateralized debt obligations, and insurance policies known as credit default swaps were written to pay off in case these securities defaulted. CDOs made up of CDSs were becoming popular.
The financial system had become so opaque that more sophisticated investors began to take advantage of those who couldn’t keep up, selling securities with the expectation that their prices would fall. Some investors even bought the riskiest tranches of securities simply to make sure the rest could be sold and then bet big that the securities would fall apart. This Alice-in-Wonderland strategy reaped enormous profits, as the money lost on the riskiest tranches was more than made up by bets against the rest. 7
The first clear cracks in the financial system appeared in early 2007, as mortgage lenders began reporting mounting delinquencies and defaults. In early March, global banking behemoth HSBC warned that it faced large losses on mortgage investments. HSBC had purchased subprime lender Household Finance not long before, hoping to cash in on the U.S. housing boom. Instead, HSBC became the first big victim. 8 Smaller finance companies were also reporting dismal earnings, driven by souring mortgage loans, but HSBC was the first big firm to acknowledge a problem. 9 Subprime mortgage lending became a dirty word on Wall Street.
By summer, the blue-chip investment house Bear Stearns was also in trouble. Bear was a big player in the mortgage world, originating loans, securitizing them, and selling them to investors, or to itself through hedge funds it controlled. Two of Bear’s funds had run into trouble as the value of their mortgage securities began to fall. Bear put additional money into the funds to shore them up and secured loans from other banks collateralized by the funds’ assets, but it all came undone in just a few weeks as house prices and the value of mortgage securities continued to plunge.
Bear’s problems began to threaten the wider financial system. Spreads began to widen between Libor—the London Interbank Offered Rate, which large banks pay when they loan each other money—and Treasury yields (see Figure 1.6). This signaled mounting angst in the financial system. Banks were even charging their biggest peers more for loans, out of fear they wouldn’t be repaid. Sensing trouble, the Federal Reserve finally began to cut its benchmark interest rate in August but did so too slowly and too late. 10
Figure 1.6. Difference between three-month Libor and Treasury bill yields.
Source: Federal Reserve Board
Bear Stearns was forced to sell itself at a fire-sale price in March 2008. By then, no one was willing to lend it money, and with cash running out, the firm turned to the Federal Reserve for help. But Bear received less help than it had hoped for. Rather than bailing it out, the Fed arranged a sale of the firm, offering JPMorgan Chase an attractive loan to sweeten the deal. It was a classic response by the central bank: Instead of allowing a large financial firm to collapse in a disorderly bankruptcy that could disrupt the system, the government stepped in. Bear was not the first big Wall Street firm to be deemed too big to fail: hedge fund Long-Term Capital Management had received similar treatment during the Asian crisis in 1998. So had Citigroup when it faced trouble over bum commercial real estate deals in the early 1990s. Bear shareholders took a big hit, but the company’s creditors were made whole.
The government’s intervention helped, at least for a while. The Fed grew more aggressive, lowering interest rates and offering financial institutions cheap loans to try to settle the financial system. The Libor-Treasury spread narrowed, signaling the financial crisis had eased. The Bush administration offered a fiscal stimulus in the form of a sizable tax rebate. The housing market continued to deflate, but the economy seemed to stabilize. It was only a brief respite.