2007 Financial Crisis Explanation, Causes, and Timeline
Here's How They Missed the Early Clues of the Financial Crisis
The 2007 financial crisis is the breakdown of trust that occurred between banks the year before the 2008 financial crisis. It was caused by the subprime mortgage crisis, which itself was caused by the unregulated 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 to prevent an economic collapse. Despite these efforts, the financial crisis still led to the Great Recession.
- The subprime mortgage crisis started in 2007 when the housing industry’s asset bubble burst.
- With the previous years’ increasing home values and low mortgage rates, houses were bought not as places to live in, but as investments.
- Government entities like Fannie Mae and Freddie Mac guaranteed mortgages, even if they were subprime or those lent to people who wouldn’t normally qualify for loans.
- Since the financial industry heavily invested in mortgage-backed derivatives, the housing industry’s downturn became the financial industry’s catastrophe.
- The 2007 financial crisis ushered in the 2008 Great Recession.
February 2007: Homes Sales Peak
In February 2007, existing home sales peaked at an annual rate of 5.79 million. Prices had already begun falling in July 2006, when they hit $230,400. Some said it was because the Federal Reserve had just raised the fed funds rate to 5.25%. In January 2007, new homes prices peaked at $254,400.
Even though each month brought more bad news about the housing market, economists couldn’t agree on how dangerous it was. Definitions of recession, bear market, and a stock market correction are well standardized. The same is not true for a housing market slump.
The research did show that price declines of 10%-15% were enough to eliminate most homeowners’ equity. Without equity, defaulting homeowners had little incentive to pay off a house they could no longer sell.
But economists didn’t think prices would fall that far. They also believed homeowners would take their homes off the market before selling at such a loss. They assumed homeowners would refinance. Mortgage rates were only half those in the 1980 recession. Economists thought that would be enough to allow mortgage holders to refinance, reducing foreclosures. They didn’t consider that banks wouldn’t refinance a mortgage that was upside down. Banks wouldn’t accept a house as collateral if it were lower in value than the loan.
February 26, 2007: Greenspan Warns of a Recession, But the Fed Ignores It
On February 26, former Federal Reserve Chairman Alan Greenspan warned that a recession was possible later in 2007. A recession is two consecutive quarters of negative gross domestic product growth. He also mentioned that the U.S. budget deficit was a significant concern. His comments triggered a widespread stock market sell-off on February 27.
On February 28, Fed Chairman Ben Bernanke’s testified at the House Budget Committee. He reassured markets that the United States would continue to benefit from another year of its Goldilocks economy.
On March 2, 2007, the Federal Reserve Bank of St. Louis President William Poole said that the Fed predicted the economy would grow 3% that year. Poole added that he saw no reason for the stock market to decline much beyond current levels. He said stock prices were not overvalued as they were before the 2000 decline.
March 6, 2007: Stock Market Rebounds After Worst Week in Years
On March 6, 2007, stock markets rebounded. The Dow Jones Industrial Average rose 157 points or 1.3% after dropping more than 600 points from its all-time high of 12,786 on February 20.
Did that mean everything was okay 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. A share of stock is a piece of that corporation. Corporate earnings depend on the overall U.S. economy. The stock market then is an indicator of investors’ beliefs about the state of the economy. Some experts say the stock market is a six-month leading indicator.
The stock market also depends on investors’ beliefs about other investment alternatives, including foreign stock exchanges. In this case, the sudden 8.4% 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. These allow speculators to borrow money to buy and sell large amounts of stocks. Thanks to these speculators, markets can decline suddenly.
For these reasons, sudden swings in the U.S. stock market can occur that is 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.
March 2007 - Hedge Funds Housing Losses Spread Subprime Misery
By March 2007, the housing slump had spread to the financial services industry. Business Week 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 of the hedge fund investments were tainted with toxic debt.
Since hedge funds use sophisticated derivatives, the impact of the downturn was magnified. Derivatives allowed hedge funds to borrow money to make investments. They did this to earn higher returns in a good market. When the market turned south, the derivatives then magnified their losses. In response, the Dow plummeted 2% on Tuesday, the second-largest drop in two years. The drop in stocks added to the subprime lenders’ miseries.
April 11, 2007 - Fed Ignores Warning Signs, Stock Market Disapproves
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.
April 17, 2007: Help for Homeowners Not Enough
On April 17, 2007, the Federal Reserve suggested that the federal financial regulatory agencies should encourage lenders to work out loan arrangements, rather than foreclose. Alternatives to foreclosure included converting the loan to a fixed-rate mortgage and receiving credit counseling through the Center for Foreclosure Alternatives. Banks that worked with borrowers in low-income areas could have received Community Reinvestment Act benefits.
In addition, Fannie Mae and Freddie Mac committed to helping subprime mortgage holders keep their homes. They launched new programs to help homeowners avoid default. Fannie Mae developed a new effort called “HomeStay." Freddie modified its program called "Home Possible." 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 already underwater, and by this time, that was most of them.
April 26, 2007: Durable Goods Orders Forecast Recession
The business press and the stock market celebrated a 3.4% increase in durable goods orders. This result was better than the 2.4% increase in February and much better than the 8.8% decline in January. Wall Street celebrated because it looked like businesses were spending more on orders for machinery, computer equipment, and the like. It meant they were getting more confident in the economy.
But comparing the orders on a year-over-year basis told a different story. When compared to 2006, March durable goods orders declined by 2%. This decline was worse than February's year-over-year decline of 0.4% and January's increase of 2%. In fact, this softening trend in durable goods orders had been going on since last April.
Why are durable goods orders so important? They represent the orders for big-ticket items. Companies will hold off making purchases if they aren't confident in the economy. Even worse, fewer orders mean declining production. That leads to a drop in GDP growth. Economists should have paid more attention to this aspect of this critical leading indicator.
June 19, 2007: Home Sales Forecast Revised Down
The National Association of Realtors forecast home sales would fall to 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 the NAR’s May forecast of 6.3 million sales in 2007 and 6.5 million sales in 2008.
The NAR also predicted the national median existing-home price would decline by 1.3% to $219,100 in 2007. It thought prices would recover by 1.7% 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 a high of $226,800 in the second quarter of 2006.
August 2007: Fed Lowers Rate to 4.75%
In a dramatic action, the Federal Open Market Committee (FOMC) voted to lower the benchmark fed funds rate a half-point down from 5.25%. This reduction was a bold move since the Fed prefers to adjust the rate by a quarter-point at a time. It signaled an about-face in the Fed’s policy. The Fed lowered the rate two more times until it reached 4.25% in December 2007.
Banks had stopped lending to each other because they were afraid of being caught with bad subprime mortgages. The Federal Reserve believed lower rates would be enough to restore liquidity and confidence.
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 because they were afraid to get stuck with subprime mortgages as collateral. As a result, the lending rate was rising for short-term loans.
The London Interbank Offered Rate (LIBOR) rate usually is a few tenths of a point above the fed funds rate. By September 2007, it was almost a full point higher. The divergence of the historical LIBOR rate from the fed funds rate signaled the coming economic crisis.
October 22, 2007: Kroszner Warned Crisis Not Over
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."
Kroszner observed that collateralized debt obligations and other derivatives were so complex that it was difficult for investors to determine what the real value 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 predicted that the collateralized debt obligation (CDO) markets would never return to health. He saw that investors couldn’t ascertain the price of these complicated financial products. Everyone realized that these complicated derivatives, which even the experts had trouble understanding, could critically damage the country's finances.
In October, existing-home sales fell 1.2% to a rate of 4.97 million. The sales pace was the lowest since the National Association of Realtors began tracking in 1999. Home prices fell 5.1% from the prior year to $207,800. Housing inventory rose at1.9% to 4.45 million, a 10.8-month supply.
November 21, 2007: Treasury Creates $75 Billion Superfund
Treasury Secretary Henry Paulson convinced three banks, Citigroup, JPMorgan Chase, and Bank of America, to set up a $75 billion superfund. BlackRock managed the superfund for buying distressed portfolios of defunct subprime mortgages. The fund would provide liquidity to banks and hedge funds that bought the asset-backed commercial paper and mortgage-backed securities that lost value.
The U.S. Treasury backed the superfund to ward off further economic decline. 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.
December 12, 2007: Fed Announces TAF
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, the Fed created an innovative new tool, the Term Auction Facility (TAF). It supplied short-term credit to banks with sub-prime mortgages.
The Fed held its first two $20 billion auctions on December 11 and December 20. Since these auctions were loans, all money was paid back to the Fed. TAF didn't cost taxpayers anything.
If the banks had defaulted, taxpayers would have had to foot the bill as they did with the Savings and Loan Crisis. It would have signaled that the financial markets could no longer function. To prevent this, the Fed continued the auction program throughout March 8, 2010.
TAF gave banks a chance to unwind their toxic debt gradually. It also gave some, like Citibank and Morgan Stanley, a chance to find additional funds.
Dec 2007 - Foreclosure Rates Double
RealtyTrac reported that the rate of foreclosure filings in December 2007 was 97% higher than in December 2006. The total foreclosure rate for all of 2007 was 75% higher than in 2006. This growth means that foreclosures were increasing at a rapid rate. In total, 1% of homes were in foreclosure, up from 0.58% in 2006.
The Center for Responsible Lending estimated that foreclosures would increase by 1-2 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.
Home sales fell 2.2% to 4.89 million units. Home prices fell 6% to $208,400. It was the third price drop in four months.
The housing bust 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.
The crisis in banking 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, some failed. The government barely kept one step ahead of a complete financial collapse.