Subprime Crisis Background Information - Stages of The Crisis

Stages of The Crisis

The crisis has gone through stages. First, during late 2007, over 100 mortgage lending companies went bankrupt as subprime mortgage-backed securities could no longer be sold to investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial institutions have recognized massive losses as they adjust the value of their mortgage backed securities to a fraction of their purchased prices. These losses as the housing market continued to deteriorate meant that the banks have a weaker capital base from which to lend. Third, during Q1 2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with $30 billion in government guarantees, after it was unable to continue borrowing to finance its operations.

Fourth, during September 2008, the system approached meltdown. In early September Fannie Mae and Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the U.S. government as mortgage losses increased. Next, investment bank Lehman Brothers filed for bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became insolvent and were sold to stronger banks. The world's largest insurer, AIG, was 80% nationalized by the U.S. government, due to concerns regarding its ability to honor its obligations via a form of financial insurance called credit default swaps.

These sequential and significant institutional failures, particularly the Lehman bankruptcy, involved further seizing of credit markets and more serious global impact. The interconnected nature of Lehman was such that its failure triggered system-wide (systemic) concerns regarding the ability of major institutions to honor their obligations to counterparties. The interest rates banks charged to each other (see the TED spread) increased to record levels and various methods of obtaining short-term funding became less available to non-financial corporations.

It was this "credit freeze" that some described as a near-complete seizing of the credit markets in September that drove the massive bailout procedures implemented by worldwide governments in Q4 2008. Prior to that point, each major U.S. institutional intervention had been ad-hoc; critics argued this damaged investor and consumer confidence in the U.S. government's ability to deal effectively and proactively with the crisis. Further, the judgment and credibility of senior U.S. financial leadership was called into question.

Since the near-meltdown, the crisis has shifted into what some consider to be a deep recession and others consider to be a "reset" of economic activity at a lower level, now that enormous lending capacity has been removed from the system. Unsustainable U.S. borrowing and consumption were significant drivers of global economic growth in the years leading up to the crisis. Record rates of housing foreclosures are expected to continue in the U.S. during the 2009-2011, continuing to inflict losses on financial institutions. Dramatically reduced wealth due to both housing prices and stock market declines are unlikely to enable U.S. consumption to return to pre-crisis levels.

Thomas Friedman summarized how the crisis has moved through stages:

When these reckless mortgages eventually blew up, it led to a credit crisis. Banks stopped lending. That soon morphed into an equity crisis, as worried investors liquidated stock portfolios. The equity crisis made people feel poor and metastasized into a consumption crisis, which is why purchases of cars, appliances, electronics, homes and clothing have just fallen off a cliff. This, in turn, has sparked more company defaults, exacerbated the credit crisis and metastasized into an unemployment crisis, as companies rush to shed workers.

Alan Greenspan has stated that until the record level of housing inventory currently on the market declines to more typical historical levels, there will be downward pressure on home prices. As long as the uncertainty remains regarding housing prices, mortgage-backed securities will continue to decline in value, placing the health of banks at risk.