2006 and Beyond: Financial Crisis and Response

During the early 2000s

During the early 2000s, low mortgage rates and expanded access to credit made homeownership possible for more people, increasing the demand for housing and driving up house prices. The housing boom got a boost from increased securitization of mortgages—a process in which mortgages were bundled together into securities that were traded in financial markets. Securitization of riskier mortgages expanded rapidly, including subprime mortgages made to borrowers with poor credit records. House prices faltered in early 2006 and then started a steep slide, along with home sales and construction. Falling house prices meant that some homeowners owed more on their mortgages than their homes were worth. Starting with subprime mortgages, more and more homeowners fell behind on their payments. Eventually, this spread to prime mortgages as well. The rising number of delinquencies on subprime mortgages was a wake-up call to lenders and investors that many residential mortgages were not nearly as safe as once believed. As the mortgage meltdown intensified, the magnitude of expected losses rose dramatically. Because millions of U.S. mortgages were repackaged as securities, losses spread across the globe. It became very difficult to determine the value of many loans and mortgage-related securities. In addition, the widespread use of complex and exotic financial instruments made it even harder to figure out the vulnerability of financial institutions to losses. Institutions became increasingly reluctant to lend to each other.

The situation reached a crisis point in 2007 when these fears about the financial health of other firms led to massive disruptions in the wholesale bank lending market. As a result, rates on short-term loans rose sharply relative to the overnight federal funds rate. In the fall of 2008, two large financial institutions failed: the investment bank Lehman Brothers and the savings and loan Washington Mutual. The extensive web of connections among major financial institutions meant that the failure of one could start a cascade of losses throughout the financial system, threatening many other institutions. Confidence in the financial sector collapsed and stock prices of financial institutions around the world plummeted. Banks were unable to sell most types of loans to investors because securitization markets had stopped working. As a result, banks and investors clamped down on many types of loans by tightening standards and demanding higher interest rates—a classic credit crunch. Tight credit weakened spending on big-ticket items financed by borrowing: houses, cars, and business investment. The hit to household wealth was another factor causing people to cut back on spending as they struggled to rebuild depleted savings. With demand weakening, businesses canceled expansion plans and laid off workers. The U.S. economy entered a recession, a period in which the level of economic activity was shrinking, in December 2007. The recession had been relatively mild until the fall of 2008 when financial panic intensified, causing job losses to soar.

As short-term markets froze, the Federal Reserve expanded its own collateralized lending to financial institutions to ensure that they had access to the critical funding needed for day-to-day operations. In March 2008, the Federal Reserve created two programs to provide short-term secured loans to primary dealers similar to discount-window loans provided to banks. Conditions in these markets improved considerably in 2009. The possible failure of the investment bank Bear Stearns early in 2008 carried the risk of a domino effect that would have severely disrupted financial markets. In order to contain the damage, the Federal Reserve provided non-recourse loans to the bank JP Morgan Chase to facilitate its purchase of certain Bear Stearns assets. Following the collapse of the investment bank Lehman Brothers, financial panic threatened to spread to several other key financial institutions, potentially leading to a cascade of failures and a meltdown of the global financial system. The Federal Reserve provided secured loans to the giant insurance company American International Group (AIG) because of its central role guaranteeing financial instruments.

In normal times, banks borrow from each other for terms ranging from overnight to several months. Starting in August 2007, banks became increasingly reluctant to make short-term loans to each other. In response, the Federal Reserve increased the availability of one- and three-month discount-window loans to banks through the creation of the Term Auction Facility. It also created swap lines with foreign central banks to increase the availability of dollar-denominated loans to banks in other countries. In the spring of 2009, the Federal Reserve, in conjunction with other federal regulatory agencies, conducted an exhaustive and unprecedented review of the financial condition of the 19 largest U.S. banks. This included a "stress test" that measured how well these banks could weather a bad economy over the next two years. Banks that didn't have enough of a capital cushion to protect them from loan losses under the most adverse economic scenario were required to raise new money from the private sector or accept federal government funds from the Troubled Asset Relief Program.

In response to the economic crisis, the Federal Reserve’s policy making body, the Federal Open Market Committee, slashed its target for the federal funds rate over the course of more than a year, bringing it nearly to zero by December 2008. This is the lowest level for federal funds in over 50 years and effectively is as low as this key rate can go. Cutting the federal funds rate helped lower the cost of borrowing for households and businesses on mortgages and other loans. To stimulate the economy and further lower borrowing costs, the Federal Reserve turned to unconventional policy tools. It purchased $300 billion in longer-term Treasury securities, which are used as benchmarks for a variety of longer-term interest rates, such as corporate bonds and fixed-rate mortgages. To support the housing market, the Federal Reserve authorized the purchase of $1.25 trillion in mortgage-backed securities guaranteed by agencies such as Freddie Mac and Fannie Mae and about $175 billion of mortgage agency longer-term debt. These Federal Reserve purchases have reduced mortgage interest rates, making home purchases more affordable.