2007 Financial Crisis: Explanation, Causes, Timeline

Here's How They Missed the Early Clues of the Financial Crisis

The 2007 financial crisis is the breakdown of trust within the financial system. It was caused by the subprime mortgage crisis, which itself was caused by the use of derivatives. This timeline includes the early warning signs, causes, and signs of breakdown. It also recounts the steps taken by the U.S. Treasury and the Federal Reserve. Unfortunately, it was not enough to prevent the 2008 financial crisis and the Great Recession.

February 2007: Homes Sales Peak

February 2007 was the best month ever for home sales. Photo by Justin Sullivan/Getty Images

Resale single-family home sales peaked in February 2007, when they were at an annual rate of 5.88 million. By September, single-family home resales had declined 25 percent to 4.38 million.

Furthermore, resale single-family home sales were projected to fall to a 4.9 million rate in Q1 2008, down 23 percent from 2007. This was as bad as the 24 percent decline experienced during the Great Depression of 1929. It would be similar to the 22 to 40 percent decline in Texas and other oil-producing states during the S&L Crisis in 1989.

In June 2007, single-family home resale median prices peaked at $229,200. By September, the median price of an existing single-family home has declined 8 percent to $210,200 according to the National Association of Realtors. By December 2007, prices declined 10 percent from their peak of $223,000 in 2006. (Source: “Existing Single Family Home Sales,” National Association of Realtors, September 2007. “U.S. Economic Outlook,” NAR, January 2008.)

As each month brought more bad news about the housing market, economists didn't agree on how bad it was. Definitions of recessionbear market and a stock market correction are well standardized, but the same is not true for the housing market. Economists' studies show that housing price declines of 10 to 15 percent are enough to eliminate equity and create a snowball effect that eventually creates severe pain for homeowners. (Source: "When Does a Housing Slump Becomes a Bust?" International Herald Tribune, June 17, 2007.)

Most people believed that home prices probably wouldn't fall as far, since most homeowners take their homes off the market before selling at such a loss. Furthermore, mortgage rates were "only" around 6 percent, only half the rate they were in the 1980 recession. The Fed promised to further lower rates, keeping needed liquidity in the mortgage market. Most people thought that would be enough to allow mortgage holders to refinance, reducing foreclosures.

March 2, 2007: Fed's Bernanke, Poole Counter Greenspan Recession Warning

Greenspan Bernanke
Ben Bernanke (R) flanked by Alan Greenspan (L) speaks after being nominated by U.S President George W. Bush to be Federal Reserve chairman October 24, 2005 in Washington, DC. Photo by Mark Wilson/Getty Images

On March 2, 2007, Federal Reserve Bank of St. Louis President William Poole said that the U.S. economy is forecast to grow 3 percent in 2007. A recession is when two consecutive quarters of negative gross domestic product growth occur.

Poole’s comment seemed to counter former Federal Reserve Chairman Alan Greenspan’s widely reported statement that a recession was possible later in 2007. Greenspan's comment, made on February 26, apparently triggered a widespread stock market sell-off on February 27. Greenspan also mentioned that the U.S. budget deficit was a significant concern.

Poole’s comment reiterated current Federal Reserve Chairman Ben Bernanke’s testimony to the House Budget Committee on February 28, which sought to reassure markets that the United States would continue to benefit from another year of its Goldilocks economy.

Poole added that he saw no reason for the stock market to decline much beyond current levels, since stock prices were not overvalued as they were before the 2000 decline. (Source: "Greenspan Is Still Able to Move Markets," New York Times, March 1, 2007, "Fed's Poole Says No Recession Coming," Bloomberg, March 2, 2007.) 

March 6, 2007: Stock Market Rebounds After Worst Week in Years

Worried Stock Trader
A trader works on the floor of the New York Stock Exchange (NYSE) September 30, 2008 in New York City. The Dow rose 485.21 points after losing 777 points the day before. Credit: Spencer Platt/Getty Images

On March 6, 2007, stock markets rebounded.

  • Dow Jones Industrial Average - up 157 points (1.3 percent), after dropping more than 600 points from its all-time high of 12,786 on February 20,
  • S&P 500 - up 21 points (1.5 percent), after falling 80 points from its high of 1,453 on February 15,
  • NASDAQ - up 44 points (1.9 percent), percent after losing 7 percent since its high of 2,524 on February 22.

Did that mean everything was OK with the U.S. economy? Not necessarily. For one thing, the stock market reflects investors' beliefs about the future value of corporate earnings. If investors think earnings will go up, they will pay more for a share of stock, which is a piece of that corporation. Corporate earnings depend on the overall U.S. economy. Therefore, the stock market is an indicator of investors’ beliefs about the state of the economy. Some experts say the stock market is actually a leading indicator of about six months out.

The stock market is also dependent on investors’ beliefs about other investment alternatives, including foreign stock exchanges. In this case, the sudden 8.4 percent drop in China’s Shanghai index caused a global panic, as investors sought to cover their losses. A big cause of sudden market swings is the unknown effects of derivatives, which allow speculators to borrow money to buy and sell large amounts of stocks. Thanks to these speculators, markets can decline suddenly, as happened last week.

For these reasons, sudden swings in the U.S. stock market can occur that are no reflection on the U.S. economy. In fact, the market upswing occurred despite several reports that indicated the U.S. economy was doing more poorly than expected. (Source: “Productivity Is Less than Estimated, and Pay Is Higher,” New York Times, March 7, 2007.)

March 2007 - Hedge Funds Housing Losses Spread Subprime Misery

Hedge funds suffered from subprime mortgage investments. Photo by Justin Sullivan/Getty Images

By March 2007, the housing slump was spreading to the financial industry. BusinessWeek reported that hedge funds had invested an unknown amount in mortgage-backed securities. Unlike mutual funds, the Securities and Exchange Commission didn’t regulate hedge funds. No one knew how many derivatives or investors were affected by mortgage defaults. Since hedge funds use sophisticated derivatives, the impact of the downturn was magnified. Derivatives allowed hedge funds to essentially borrow money to make investments, creating higher returns in a good market, and greater losses in a bad one. In response, the Dow Jones Industrial Average plummeted 2 percent on Tuesday, the second largest drop in two years. (Source: "The Mortgage Mess Spreads," BusinessWeek online, March 7, 2007, "Stocks Plummet on Subprime Lender Woes," Yahoo News, March 13, 2007.) More

April 11, 2007 - Fed Ignores Warning Signs, Stock Market Disapproves

Bernanke and Paulson
Federal Reserve Board Chairman Ben Bernanke (R) testifies before the Senate Banking, Housing and Urban Affairs Committee as U.S. Treasury Secretary Henry Paulson watches on Capitol Hill September 23, 2008 in Washington, DC. Photo by Chip Somodevilla/Getty Images

On April 11, 2007, the Federal Reserve released the minutes of the March Federal Open Market Committee meeting. The stock market dropped 90 points in disapproval. Worried investors had hoped for a decrease in the fed funds rate at that meeting.

Instead, the Fed was worried more about inflation. It ruled out a return to expansionary monetary policy anytime soon. Lower interest rates were needed to spur homeowners into buying homes. The housing slump was slowing the U.S. economy. More

April 17, 2007: Help for Homeowners Not Enough

A bank owned for sale sign
A bank owned for sale sign is posted in front of a foreclosed home May 7, 2009 in Antioch, California. Photo by Justin Sullivan/Getty Images

On April 17, 2007, the Federal Reserve announced that the federal financial regulatory agencies that oversee lenders encourage them to work with lenders to work out loan arrangements, rather than foreclose. Alternatives to foreclosure include converting the loan to a fixed-rate mortgage, and receiving credit counseling through the Center for Foreclosure Solutions. Banks that work with borrowers in low-income areas can also receive Community Reinvestment Act benefits.

In addition, Fannie Mae and Freddie Mac committed to helping subprime mortgage holders keep their home. Fannie Mae developed a new effort called “HomeStay."  Freddie modified its program called "HomePossible." It gave borrowers ways to get out from under adjustable-rate loans before interest rates reset at a higher level, making monthly payments unaffordable. But, these programs didn't help homeowners who were underwater. In other words, most of them. (Source: "Fannie, Freddie to Offer Subprime Help," CNNMoney.com. "Statement on Working with Mortgage Borrowers,” Federal Reserve.)

April 26, 2007: Durable Goods Orders Forecast Recession

Boeing 737
Jets are an important component of durable goods orders. Photo: Scott Olson/Getty Images

The business press and the stock market celebrated a 3.4 percent increase in durable goods orders. This was better than the 2.4 percent increase in February and much better than the 8.8 percent decline in January. Wall Street celebrated because it looked like businesses were spending more on business orders for machinery, computer equipment, and the like increased 3.4 percent, which meant they were getting more confident in the economy.

The year-over-year changes told a very different story. When compared to 2006, March durable goods orders actually declined by 2 percent, worse than February's year-over-year decline of .4 percent, and January's increase of 2 percent. In fact, this softening trend in durable goods orders had been going on since last April.

Why are durable goods orders so important? Well, since they represent the orders for big ticket items, businesses will hold off making the purchases if they aren't confident in the economy. Furthermore, declining orders mean declining production. And that means a decline in GDP growth. That's why the durable goods orders report is generally considered a leading indicator.

June 19, 2007: Home Sales Forecast Revised Down

Vacant Building
A vacant house is seen through a fence on June 27, 2007 in Stockton, California. Photo: Justin Sullivan/Getty Images

The National Association of Realtors forecast that home sales were projected to total 6.18 million in 2007 and 6.41 million in 2008. That was lower than the 6.48 million sold in 2006. It was lower than May's forecast of 6.3 million sales in 2007 and 6.5 million sales in 2008.

The NAR also forecast the national median existing-home price to decline by 1.3 percent to $219,100 in 2007 before rising 1.7 percent in 2008. That was better than May's forecast of a low of $213,400 in the first quarter of 2008. It was still down from the high of $226,800 in the second quarter of 2006.

August 2007: Fed Lowers Rate to 4.75 Percent

Ben Bernanke was the Federal Reserve Chairman during the financial crisis. Photo: Win McNamee/Getty Images

In a dramatic action, the FOMC voted to lower the benchmark fed funds rate a half point down from 5.25 percent. This is a bold move, since the Fed usually only adjusts the rate by a quarter point at a time. It was meant to signal that the Fed will be aggressive in its expansive monetary policy to support the shaky financial system. It lowered the rate four times until it reached 4.25 percent in December 2007.

Banks had stopped lending to each other because they were afraid of getting caught with bad subprime mortgages. The Federal Reserve stepped in to restore liquidity and confidence. And stepped in. And stepped in. More

September 2007: LIBOR Rate Unexpectedly Diverges

As early as August 2007, the Fed had begun extraordinary measures to prop up banks. They were starting to cut back on lending to each other, afraid to get stuck with subprime mortgages as collateral. As a result, the lending rate was rising for short-term loans. This Libor rate usually is a few tenths of a point above the fed funds rate. By September 2007, it was nearly a full point higher. For more, see Historical Libor Rate. More

November 21, 2007: Treasury Creates $75 Billion Superfund

Henry Paulson
Former U.S. Treasury Secretary Henry Paulson testifying before the House Financial Services Committee on Capitol Hill November 18, 2008 in Washington, DC. Photo: Chip Somodevilla/Getty Images

In November, then Treasury Secretary Paulson convinced three banks, Citigroup, JPMorgan Chase and Bank of America, to set up a $75 billion superfund. It was managed by Blackrock Investments to buy distressed portfolios of defunct subprime mortgages. 

The fund would provide liquidity to banks and hedge funds that bought asset-backed commercial paper and mortgage-backed securities that lost value. The U.S. Treasury backed the Superfund to ward off further economic decline. (Source:  Banks SIV Superfund Taps Blackrock,” FTAlphaville, November 11, 2007.)

The goal was to give the banks enough time to figure out how to value these derivatives. Banks would be guaranteed by the federal government to take on more subprime debt. But even a guarantee of zero losses wasn't enough to convince banks to be the ones stuck with the debt. The Superfund was a failure. The government was going to have to go it alone.

October 22, 2007: Kroszner Warned Crisis Not Over

NYSE outside
Outside the New York Stock Exchange in Manhattan. This is where CDOs spread crisis to investors. Photo: Spencer Platt/Getty Images

Federal Reserve Governor Randall Kroszner said that, for credit markets, "the recovery may be a relatively gradual process, and these markets may not look the same when they re-emerge." (Source: “Institute of International Bankers Annual Breakfast Dialogue,” Federal Reserve, October 22, 2007.)

Kroszner observed that collateralized debt obligations and other derivatives were so complex that it's difficult for investors to determine what the real value and price should be. As a result, investors paid whatever the seller asked, based on his sterling reputation. 

When the Subprime Mortgage Crisis hit, investors began to doubt the sellers. Trust declined, and panic ensued, spreading to banks. Kroszner forecast that the CDO markets would not return to their previous ebullient state. He correctly warned that investors could not determine how to accurately price these complicated financial products. It was alarming to everyone that these complicated derivatives, which are barely understood by even the experts, could have such an important impact on the country's finances. 

December 21, 2007: Fed Auctions $40 Billion in Loans

Lowering the fed funds rate wasn't enough to restore bank confidence. Banks were afraid to lend to each other. No one wanted to get caught with bad debt on their books at the end of 2007.

To keep liquidity in the financial markets, Federal Reserve Chairman Ben Bernanke created an innovative new tool, the Term Auction Facility. It to supplied short-term credit to banks with sub-prime mortgages. The Fed held two $20 billion auctions on December 11 and December 20. Since these auctions are loans, the money should get paid back to the Fed, and so it shouldn't cost the taxpayer anything. (Source: “Press Release,” Federal Reserve, December 12, 2007.)

Of course, if the banks default, then ultimately the taxpayer may have to foot the bill, similar to the Savings and Loan Crisis. This costs the taxpayers $124 billion. If the banks default, it would signal a serious lack of confidence in the functioning of the financial markets. To prevent this from occurring, the Fed will continue to schedule auctions throughout January. This should give banks a chance to sort out who has the bad loans on their books and how bad it is. (Source: “Press Release,” Federal Reserve, December 21, 2007.)

It would also give these banks a chance to find additional funds, similar to recent action taken by Citibank and Morgan Stanley. (Source: “Citi Sells Stake to Abu Dhabi Fund,” November 11, 2007. “Morgan Stanley Posts Loss on Writedown,” December 19, 2007.)

Dec 2007 - Foreclosure Rates Double

Tracy Munch watches as an eviction team removes furniture from her foreclosed house
Tracy Munch watches as an eviction team removes furniture from her foreclosed house February 2, 2009 in Adams County, Colorado. She and her husband had been renting from an owner, who collected the monthly payments but had stopped paying his mortgage. Photo by John Moore/Getty Images

RealtyTrac reported that the rate of foreclosure filings in December 2007 were 97 percent higher than in December 2006. The total foreclosure rate for all of 2007 was 75 percent higher than 2006. This means that foreclosures are increasing at a rapid rate. In total, 1 percent of homes were in foreclosure, up from .58 percent in 2006. (Source: “U.S. Foreclosure Activity Increases 75 percent in 2007,” RealtyTrac, January 29, 2008.)

According to the Center for Responsible Lending, foreclosures will increase by 1 million to 2 million over the next two years. That's because 450,000 subprime mortgages reset each quarter. Borrowers couldn't refinance as they expected, due to lower home prices and tighter lending standards.

The Center warned that these foreclosures would depress prices in their neighborhoods by a total of $202 billion, causing 40.6 million homes to lose an average of $5,000 each. (Source: “Subprime Spillover,” Center for Responsible Lending, January 18, 2008.)

October 2007: Private Equity Deals Plummet

shake hands agree on deal
Photo by Comstock/Getty Images

The crisis cooled off the fervor of investors for private equity, according to a recent report released by Prequin. The analysts estimated that successful closings of private equity offers declined to $91 billion in Q3 2007, down from an all-time high of $177 billion in Q2 2007. The total funds raised in 2006 was $486 billion, which was also record-breaking. (Source: “Private Equity Spotlight,” Prequin, October 2007.)

Q4 2007: GDP Predicted to Fall Thanks to the Slowing Housing Market

laid off man
Slower economic growth leads to unemployment. Photo: Clerkenwell/Getty Images

The NAR predicted a negative growth rate for Q4 2007. Furthermore, Americans used their home equity as an ATM machine, so lower home prices translate into lower furniture and other retail sales. Experts forecast GDP growth to slow to 2 percent for 2007, down from 2.9 percent in 2006.

The housing bust has already caused a stock market correction. Many warned that, if the housing bust continued into spring 2008, the correction could turn into a bear market, and the economy could suffer a recession

Next: 2008 Financial Crisis Timeline

U.S. Federal Reserve Chairman Ben Bernanke
U.S. Federal Reserve Chairman Ben Bernanke testifies before the House Financial Services Committee. Photo: Win McNamee/Getty Images

The crisis in banking only got worse in 2008. Banks that were highly exposed to mortgage-backed securities soon found no one would lend to them at all. Despite efforts by the Fed and the Bush Administration to prop them up, they barely succeeded. Here's a timeline of how the government barely kept one step ahead of a complete financial collapse. More