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2007 All Fall Down

“A new wave of mortgage defaults is imminent—a situation which would flood the housing market with an even greater supply of unsold homes and potentially weakens the U.S. economy as a whole. … Home prices will continue to fall.”

– Mark Grimaldi, The Navigator, January 2007

The housing market fell apart as two economic situations combined to create what many economists consider the perfect storm.  First, interest rates began to rise, and secondly, housing prices began to weaken. Troubled borrowers had only one choice, and foreclosures on subprime loans started to rise.

Initially, the federal government insisted that the problem was contained. On June 5, 2007, Fed President Ben Bernanke told a South African audience that “troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.”

That clearly wasn’t true, however. As early as March 2007, the entire housing market was suffering, with national home sales and prices seeing dramatic declines. Existing-home sales were down 13 percent their peak of 554,000 in March 2006 to 482,000 a year later, the steepest since 1989. Meanwhile, the national median price of existing homes had fallen 6 percent from a peak of $230,200 in July 2006 to $217,000 a year later.  

If the problem had been limited just to the housing market, there might have been a quick resolution. But this housing-market correction was like no other in that it led to a crisis of confidence in the global banking system.

Other events in 2007 highlighted the depth of the financial crisis.  For example, in July Bear Stearns & Co. disclosed that two of its hedge funds, which had bet heavily on securities tied to subprime mortgages, had lost nearly all of their value. When German’s IKB Deutsche Industriebank announced major subprime losses as well, forcing the German government to organize a €3.5 billion bailout in August 2007, the world began to worry.

Then, on August 9, 2007French bank BNP Paribas announced that it would not allow investors to withdraw money from three funds because it couldn’t determine the market for their holdings. “The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating,” the bank said. In other words, banks didn’t know what mortgage-backed securities holding subprime mortgages were worth, due to the tranches, and since no one was buying them, there was no market price.

As fear paralyzed the world credit markets, the world’s central bankers responded. The European Central Bank (ECB) was the first to act, with an injection €94.8 billion into European money markets, a larger infusion than the one that came after the September 11 terrorist attacks. Other central banks followed with similar, but smaller steps.  The Fed, for example, injected $38 billion into the money markets, but not in a traditional fashion.  The Fed usually buys U.S. Treasuries, but this time it bought 

might have been a quick resolution. But this housing-market correction was like no other in that it led to a crisis of confidence in the global banking system.

Other events in 2007 highlighted the depth of the financial crisis.  For example, in July Bear Stearns & Co. disclosed that two of its hedge funds, which had bet heavily on securities tied to subprime mortgages, had lost nearly all of their value. When German’s IKB Deutsche Industriebank announced major subprime losses as well, forcing the German government to organize a €3.5 billion bailout in August 2007, the world began to worry.

Then, on August 9, 2007French bank BNP Paribas announced that it would not allow investors to withdraw money from three funds because it couldn’t determine the market for their holdings. “The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating,” the bank said. In other words, banks didn’t know what mortgage-backed securities holding subprime mortgages were worth, due to the tranches, and since no one was buying them, there was no market price.

As fear paralyzed the world credit markets, the world’s central bankers responded. The European Central Bank (ECB) was the first to act, with an injection €94.8 billion into European money markets, a larger infusion than the one that came after the September 11 terrorist attacks. Other central banks followed with similar, but smaller steps.  The Fed, for example, injected $38 billion into the money markets, but not in a traditional fashion.  The Fed usually buys U.S. Treasuries, but this time it bought bonds backed by subprime mortgages, because there were so few buyers for them.  The Fed became the buyer of last resort.

On August 31, 2007 President Bush tried to intervene, outlining a plan that would help troubled subprime borrowers keep their homes. The changes to the Federal Housing Administration mortgage insurance program that would allow more people to refinance with FHA insurance if they fall behind on adjustable-rate mortgages, which offer low introductory rates that can later rise, sometimes doubling a monthly payment. White House officials estimated the initiative could help as many as 80,000 new home owners—which, interestingly, is the exact number that were able to initially buy new homes thanks to the earlier passed American Dream Down Payment Initiative.  Thanks for that!

The Fed, for its part, also followed the traditional playbook to some extent. On August 17, 2007 one week after the credit crunch first surfaced, the Fed lowered its discount rate (which it charges qualified lenders for temporary loans) from 6.25 percent to 5.75 percent. In a slightly more unusual move, the Fed also extended the duration on loans banks took out under the discount window, which is the facility through which the Fed makes loans to commercial banks (which pledge a variety of financial instruments as collateral), from overnight to 30 days.

At first these moves were well received, with the U.S. equity markets rallying to new highs in the following weeks. Still, tight credit conditions would not abate, so the Fed persisted, and soon showed it was willing to get aggressive if necessary. On September 18, the central bank cut both the discount rate and the federal funds rate, to 5.25 percent and 4.75 percent, respectively.

By the end of 2007, the discount rate was at 4.75 percent and the federal funds rate was at 4.25 percent, but it was clear these low interest rates wouldn’t be the easy fix they were in the past. Some analysts said this was because the Fed hadn’t responded quickly enough, but the medicine still didn’t match the illness.  It was impossible to value—and thus trade—banks’ assets. By December 2007, the Fed understood, and in coordination with other world central banks announced a surprise two-part plan to combat the credit crunch by pumping money into the global banking system.

First, the Fed, along with the European Central Bank (ECB), Bank of Canada, Bank of England and Swiss National Bank, created a new lending facility called a “term auction facility.” This was a hybrid of the Fed’s two normal funding methods of auctioning of funds to 21 primary dealers via a system of repurchase agreements, and the discount window available to commercial banks.[1]Under the term auction facility, the Fed auctioned off funds, but any commercial bank deemed to be in generally sound financial condition by its local Fed bank could participate (anonymously, and by pledging a wider variety of financial instruments as collateral).

Second, the Fed set up $20 billion swap lines with the ECB and $4 billion swap lines with the Swiss National Bank. Under these swap lines, the Fed agreed to loan the central banks a total of $24 billion, which the banks could in turn lend to commercial banks in Europe. This, it reasoned, would help large commercial banks in foreign countries gain access to U.S. dollars.

By then, the housing market was in dire straits. Sales of existing single-family homes fell in 2007 by 13 percent, the largest amount in 25 years. At the same time, the median home price dropped 1.8

federal funds rate was at 4.25 percent, but it was clear these low interest rates wouldn’t be the easy fix they were in the past. Some analysts said this was because the Fed hadn’t responded quickly enough, but the medicine still didn’t match the illness.  It was impossible to value—and thus trade—banks’ assets. By December 2007, the Fed understood, and in coordination with other world central banks announced a surprise two-part plan to combat the credit crunch by pumping money into the global banking system.

First, the Fed, along with the European Central Bank (ECB), Bank of Canada, Bank of England and Swiss National Bank, created a new lending facility called a “term auction facility.” This was a hybrid of the Fed’s two normal funding methods of auctioning of funds to 21 primary dealers via a system of repurchase agreements, and the discount window available to commercial banks.[1]Under the term auction facility, the Fed auctioned off funds, but any commercial bank deemed to be in generally sound financial condition by its local Fed bank could participate (anonymously, and by pledging a wider variety of financial instruments as collateral).

Second, the Fed set up $20 billion swap lines with the ECB and $4 billion swap lines with the Swiss National Bank. Under these swap lines, the Fed agreed to loan the central banks a total of $24 billion, which the banks could in turn lend to commercial banks in Europe. This, it reasoned, would help large commercial banks in foreign countries gain access to U.S. dollars.

By then, the housing market was in dire straits. Sales of existing single-family homes fell in 2007 by 13 percent, the largest amount in 25 years. At the same time, the median home price dropped 1.8 percent to $217,000, the first annual price decline on record, which goes back to 1968. Lawrence Yuan, the chief economist at the National Association of Realtors, said it was likely that the country had not experienced such a decline in housing prices since the Great Depression.