Risk Management and Financial Institutions, 4th Edition

CHAPTER 6 The Credit Crisis of 2007

Starting in 2007, the United States experienced the worst financial crisis since the 1930s. The crisis spread rapidly from the United States to other countries and from financial markets to the real economy. Some financial institutions failed. Many more had to be bailed out by national governments. The first decade of the twenty-first century was disastrous for the financial sector, and the risk management practices of financial institutions have been subjected to a great deal of criticism. As we will see in later chapters, the crisis led to a major overhaul of the way financial institutions are regulated.

This chapter examines the origins of the crisis, what went wrong, why it went wrong, and the lessons that can be learned. In the course of the chapter, we will find out about the U.S. housing market, asset-backed securities, and collateralized debt obligations.

6.1 THE U.S. HOUSING MARKET

A natural starting point for a discussion of the credit crisis of 2007 is the U.S. housing market. Figure 6.1 shows the S&P/Case-Shiller composite-10 index for house prices in the United States between January 1987 and March 2014. This tracks house prices for ten major metropolitan areas in the United States. In about the year 2000, house prices started to rise much faster than they had in the previous decade. The very low level of interest rates between 2002 and 2005 was an important contributory factor, but the bubble in house prices was largely fueled ...