Extreme Market Dislocation: The 2007 Subprime Credit Crisis

 
Although the current subprime credit crisis that has roiled global financial markets had its beginning in prior events, July 2007 has proven to be the watershed month.

On July 10th, 2007, Standard and Poors and Moodys Rating Services downgraded billions of dollars of bonds backed by sub-prime mortgages, with Fitch rating service soon following suit.

On July 18th, Bear Stearns announced that its two hedge funds that invested heavily in the subprime market were essentially worthless, with losses that would eventually total over $1.4 billion.

Events that had their beginning in the U.S. credit markets spread to global markets as the ‘contagion’ effect caused price dislocations in broad market segments and a global credit and liquidity crisis. Central banks moved to inject funds into the marketplace, the asset backed commercial paper market came to a virtual halt, and on August 18th, the U.S. Federal Reserve, acting as ‘lender of last resort’, lowered the discount rate in an effort to provide liquidity and assurance to a marketplace in panic.

As with other periods of broad price dislocation, assets that were seemingly uncorrelated now correlated and converged, and many hedge funds liquidated strong positions across all market segments in an effort to meet redemption demands amid a liquidity crunch.