Market Crashes: Housing Bubble and Credit Crisis (2007-2009)
Where: Housing centered in the United States and Britain; Credit crisis occurred around the world
The amount the market declined from peak to bottom: The S&P 500 declined 57% from its high in October 2007 of 1576 to its low in March 2009 of 676; many indicators of credit risk such as the "Ted Spread" or the option adjusted spread (OAS) on corporate bonds reached record highs
Synopsis: Following the bursting of the tech bubble and the recession of the early 2000s, the Federal Reserve kept short-term interest rates low for an extended period of time. This coincided with a global savings glut, as developing countries and commodity producing nations accumulated large financial reserves. As these excess savings were invested, global interest rates declined to record low levels. Frustrated with low returns, investors began to assume more risk by seeking higher returns wherever they could be found. For several years, global financial markets entered a period which came to be called the "Great Moderation" due to the above-average returns and below-average volatility demonstrated by a wide variety of asset classes. (Check out our Federal Reserve Tutorial.)
In the United States, the Great Moderation coincided with a housing boom, as prices soared (particularly on the two coasts and in cities such as Phoenix and Las Vegas.) Rising home prices led to rampant real estate speculation, and also fueled excessive consumer spending as people began to view their homes as a "piggy bank" that they could extract cash from to fuel discretionary purchases. As home prices soared and many homeowners "stretched" to make their mortgage payments, the possibility of a collapse grew. However, the true extent of the danger was hidden because so many mortgages had been securitized and turned into AAA-rated securities.
When the long held belief that home prices do not decline turned out to be inaccurate, prices on mortgage-backed securities plunged, prompting large losses for banks and other financial institutions. These losses soon spread to other asset classes, fueling a crisis of confidence in the health of many of the world's largest banks. Events reached their climax with the bankruptcy of Lehman Brothers in September 2008, which resulted in a credit freeze that brought the global financial system to the brink of complete collapse. (You might also want to read Case Study: The Collapse of Lehman Brothers.)
Unprecedented central bank actions combined with fiscal stimulus (notably in the US and China) helped ease some of the panic in the market place, but by late winter 2009, widespread rumors surfaced that Citigroup (NYSE:C), Bank of America (NYSE:BAC), and other large banks would have to be nationalized if the global economy was to survive. Fortunately, the aggressive actions by governments around the world eventually helped avoid financial collapse, but the credit freeze forced the global economy into the worst recession since WW2.
The credit crisis and accompanying recession caused unprecedented volatility in financial markets. Stocks fell 50% or more from their highs through March 2009 before rallying more than 50% once the crisis began to ease. In addition to stocks, most fixed income markets also displayed unprecedented volatility, with many corporate bond markets at one point forecasting bankruptcies at a level not seen since the Great Depression. Oil fell 70%, then doubled as the financial system stabilized.
The events of the housing bubble and credit crisis are likely to resonate with consumers and investors for years to come. In many countries (including the U.S.) consumers remain heavily leveraged and many homeowners are "underwater." As consumers deleverage and repair their finances, their purchasing patterns will be permanently altered. Many developed market countries have also seen a substantial deterioration in their fiscal position. While government actions helped prevent worst-case outcomes from the credit crisis, large budget deficits now represent a structural problem that may take decades to solve.
Finally, investors have experienced the most volatile and frightening markets of their life. Positive lessons, such as the importance of diversification and independent analysis can be taken from the crisis, but there are also emotional affects that must be considered. In particular, investors must remember that the events of the crisis were unusual and are unlikely to be repeated; while excessive greed in the financial markets is inappropriate, so too is excessive fear. Investors that can incorporate the lessons of the credit crisis without having their emotions unduly influenced will be best positioned for future investment success.
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