Strains in Interbank Lending Markets During The 2007 Financial Crisis
By mid-2007, cracks started to appear in markets for asset-backed securities. For example, in June 2007, ratings agencies downgraded over 100 bonds backed by second-lien subprime mortgages. Soon after, the investment bank Bear Stearns liquidated two hedge funds that had invested heavily in mortgage-backed securities (MBS) and a few large mortgage lenders filed for Chapter 11 bankruptcy protection. Strains in interbank lending markets became apparent on August 9, 2007, after BNP Paribas announced that it was halting redemptions on three of its investment funds. That morning the US dollar Libor rate climbed over 10 basis points (bps) and remained elevated thereafter. The US Libor-OIS spread ballooned to over 90bps in September whereas it had averaged 10bps in prior months.
At the following FOMC meeting (September 18, 2007), the Fed started to ease monetary policy aggressively in response to the turmoil in financial markets. In the minutes from the September FOMC meeting, Fed officials characterize the interbank lending market as significantly impaired:
“Banks took measures to conserve their liquidity and were cautious about counterparties’ exposures to asset-backed commercial paper. Term interbank funding markets were significantly impaired, with rates rising well above expected future overnight rates and traders reporting a substantial drop in the availability of term funding.”
By the end of 2007, the Federal Reserve had cut the fed funds target rate by 100bps and initiated several liquidity-providing programs and yet the Libor-OIS spread remained elevated. Meanwhile, for most of 2008, term funding conditions remained stressed. In September 2008, when the US government decided not to bail out the investment bank Lehman Brothers, credit markets went from being strained to completely broken and the Libor-OIS spread blew out to over 350bps.
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