The Great Depression Part 15 – 2007 Financial Crisis Explanation, Causes, and Timeline

Good day to each of you reading this column on the great depression and the many similarities that many Americans have faced in the 21st century.

A new year was arriving in 2007 with the hope of bailing out those in crisis—who better to bail out then the Federal Reserve. If you remember back in 1929, where was the Federal Reserve during this time? They were nowhere to be found for they showed their reluctance not to increase the money supply thus causing a money shortage.

Will this be the case in 2007 and they will do enough to prevent this recession?

Who picks up the pieces when a recession occurs? Simple, all Americans are affected greatly and we begin to rebuild again but how many times must we go thru this lesson and why do we allow those chosen to lead us, lead us astray?

Let’s examine those questions along with plummeting stock markets, mortgage giants collapsing, banking giants bankrupting or being sold and many American’s wealth lost in the stock market.

Let’s begin in 2007 with thoughts and statistics from thebalance.com 2007 Financial Crisis Explanation, Causes, and Timeline.

The original source article written by Kimberly Amadeo and reviewed by Michael J Boyle containing links to their sources can be found at thebalance.com by clicking here.

2007 Financial Crisis Explanation, Causes, and Timeline

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

BY KIMBERLY AMADEO REVIEWED BY MICHAEL J BOYLE

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.

Key Takeaways:

• 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 2007.4 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.

Upon reading the above article, Let’s review the factors that caused the “Great depression of 1929” and utilize the businessinsider.com

• The speculative boom of the 1920s
• Stock market crash of 1929
• Oversupply and overproduction problems
• Low demand, high unemployment
• Missteps by the Federal Reserve
• A constrained presidential response
• An ill-timed tariff

One can begin to check off the many comparisons between the “Great Depression of 1929” and the “Great recession of 2007-2009”. The roaring twenties have come full circle with the following revolving door:

• House Sales Peak/Foreclosures Increase Dramatically and then double/ House Sales Decline
• Federal Reserve ignores warning signs
• Stock Market takes major dip then rebounds but all is not well
• Hedge Funds become toxic debt with no SEC regulation
• Drop in GDP Growth

Look very closely on December 12, 2007 and the creation of the (TAF) or Term Auction Facility.

The Term Auction Facility (TAF) was a monetary policy used by the Federal Reserve to increase liquidity in the U.S. credit markets during the financial crisis of 2007. The TAF was a mechanism whereby the Federal Reserve auctioned collateral-backed short-term loans to depository institutions.

Term Auction Facility (TAF) Definition

I am putting the cart before the horse as TAF was created due to the divergence of the London Interbank Offered Rate (LIBOR) rate. The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.

• It is worth noting that LIBOR has been subject to manipulation, scandal, and methodological critique, making it less credible today as a benchmark rate.
• LIBOR is being replaced by the Secured Overnight Financing Rate (SOFR) on June 30, 2023, with phase-out of its use beginning after 2021.

As for the significance of the LIBOR Rate to the TAF, The divergence of the historical LIBOR rate from the fed funds rate signaled the coming economic crisis according to thebalance.com

Let us not forget that the US Treasury stepped in before thanksgiving of 2007 to create the 75-billion-dollar superfund with three leading banks: Citigroup, JPMorgan Chase and Bank of America. 14 BlackRock managed the superfund for buying distressed portfolios of defunct subprime mortgages.

Keep in mind the banks that were involved before thanksgiving of 2007 for these names will be very prominent in 2008.

The 75-billion-dollar superfund backed by the U.S. Treasury was designed to ward off economic decline thus giving banks more time to take on subprime debt and assuring banks that the U.S. government would back them. Ouch!

Let’s examine what thebalance.com statement– The fund would provide liquidity to banks and hedge funds that bought the asset-backed commercial paper and mortgage-backed securities that lost value.

Didn’t hedge funds housing losses get us into this mess? Who is picking up the tab? What is asset-backed commercial paper? According to thebalance.com, Commercial paper is a short-term debt security that corporations use to raise capital. Because of their short maturity schedules, companies often use commercial paper to cover immediate expenses such as payroll and inventory. Commercial paper has a maturity of up to 270 days, but the average is about 30 days. The issuers of this type of debt security are most often financial institutions and large corporations. Board of Governors of the Federal Reserve System.

The balance.com gives us a breakdown of the asset-backed commercial paper so you can draw your own conclusions:

• Commercial paper is a type of short-term unsecured debt security issued by financial institutions and other large corporations.
• Commercial paper is sold at a discount, meaning the buyer pays less than the face value of the security, and the rate of return is the difference between the purchase price and face value.
• There are several types of commercial paper, but most come in the form of a promissory note.
• A commercial paper is different from a bond because it has a shorter maturity and can only be issued by companies, whereas both companies and governments can issue bonds.
• Individual investors may include commercial paper in their portfolio by investing in money market funds.

The pros for an asset-based commercial paper were and supposedly a low-risk default ??, provide portfolio diversification for investors and a quick way to get cash at affordable rates. As for the cons, this was unsecured debt, an inflation risk with the possibility of inflation risk and funding source for the large and extremely creditworthy companies only.

Let’s now look at mortgage-backed securities—thebalance.com describes an (MBS) or mortgage-backed security as a bank or mortgage company makes a home loan. The bank then sells that loan to an investment bank. It uses the money received from the investment bank to make new loans.

The investment bank adds the loan to a bundle of mortgages with similar interest rates. It puts the bundle in a special company designed for that purpose. It’s called a Special Purpose Vehicle (SPV) or Special Investment Vehicle (SIV). That keeps the mortgage-backed securities separate from the bank’s other services. The SPV markets the mortgage-backed securities.

Mortgage-backed securities revolutionized the housing industry by allowing more people to purchase homes creating a housing boom for anyone whether they qualified or not including those who got “in over their head” by buying more house than they could afford. The result, subprime mortgages bundled into private labeled mortgage-backed securities which resulted in more than 50% of the mortgage finance market in 2006.

The law of supply and demand came into play when homeowners caught up with the demand of homes in 2006 and housing prices began to fall. The housing bubble had burst and the loans had come due with foreclosures and bankruptcies along with banks holding the bag.

But why? Look at the balance.com with the following insight– Mortgage-backed securities allowed non-bank financial institutions to enter the mortgage business. Before MBSs, only banks had large enough deposits to make long-term loans. They had the deep pockets to wait until these loans were repaid 15 or 30 years later. The invention of MBSs meant that lenders got their cash back right away from investors on the secondary market. The number of lenders increased. Some offered mortgages that didn’t look at a borrower’s job or assets.7 This created more competition for traditional banks. They had to lower their standards to compete.

Worst of all, MBS’s were not regulated. The federal government regulated banks to make sure their depositors were protected, but those rules didn’t apply to MBSs and mortgage brokers. Bank depositors were safe, but MBS investors were not protected at all. Ouch!

The result was massive home foreclosures in December 2007 and the beginnings of three years of the great recession. What would 2008 usher in and how would the Federal Government and Federal Reserve react to the foreclosures? Would the housing market return and would the stock market become a “bear” market?

In my column, I will answer these questions and provide more analysis on the year of 2008.

May we learn from history and not erase the lessons but take the correct action not to repeat.

May God Bless you and May you bless God in all that you say and do.

Jeff