Home > Articles > Business & Management > Finance & Investing

  • Print
  • + Share This
This chapter is from the book

Financial Shock

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

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

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.

  • + Share This
  • 🔖 Save To Your Account

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020