2007 Credit Crunch

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Sean Hinton

For a definition of the term "credit crunch," see Credit Crunch (definition). For more information on 2008 fallout within the Financial Industry see 2008 Financial Crisis

The credit crisis of 2007 started in the U.S. subprime mortgage industry. Far from being confined to the residential real estate market, the effects of the subprime collapse spread throughout the U.S. economy and into global markets. The impact has been especially rough on the financial services industry, as many investment banks had a short but extensive history of using mortgage-backed securities (or MBSs) as a way to spread risk and free up additional capital. The failure of the MBS market has shrunk the capital supply available to institutional investors, creating a snowball effect.

For example, the market for auction rate securities failed in February 2008, when Citigroup, UBS, and the other two banks that auction these securities declined to act as bidder of last resort. This refusal, driven by the scope of the market's failure and the banks' own need to minimize risk after widespread MBS write-offs ^[1], negatively impacted the cities, schools, and hospitals that issued these bonds, as well as the companies (including Intuit and Monster Worldwide) that owned them. The freezing of the auction rate securities market is one example of the wide, deep impact of the credit crunch - while its catalyst can be traced to a single source, mortgage investment, its impact cannot be as easily contained.

Who's affected by the credit crunch?

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Home construction and improvement companies

• Toll Brothers (TOL), Lennar (LEN), Pulte Homes (PHM), and D.R. Horton (DHI) are all companies involved in the construction of new homes. With falling real estate prices and a large supply of homes already on the market, these companies have been hurt by the credit crunch.

Mortgage lenders

• Countrywide Financial (CFC) is the largest mortgage originator in the U.S., making it highly exposed to both the housing and credit markets. Bank of America (BAC) announced its intention to buy Countrywide In January 2008, though the deal isn't expected to close until the third quarter of 2008.^[3]
• Wells Fargo (WFC) and Washington Mutual (WM) are the second- and third-largest mortgage originators in the U.S., respectively. Wells Fargo and WaMu do, however, have more diverse business models than Countrywide, giving them some buffer against poor performance in the mortgage industry.

Monoline bond insurers

• MBIA (MBI) and Ambac Financial Group (ABK) insure bonds and other forms of debt. These companies invested in collateralized debt obligations themselves, losing money as CDO values declined. MBIA reported a full-year 2007 net loss of $1.92 billion and a first-quarter 2008 net loss of $2.41 billion;^[4] for Ambac, these figures were $3.25 billion and $1.66 billion, respectively.^[5]

Collection agencies

• Portfolio Recovery Associates (PRAA) and Asset Acceptance Capital (AACC) are two of the only publicly traded "debt recovery" firms in the U.S. PRAA's cash collections in the first quarter of 2008 rose 18% over the first quarter of 2007.^[6] Cash collections were up 4.6% at AACC to over $100 million in the first quarter of 2008, showing the credit crunch's impact on borrowers ability to repay their debt obligations.^[7]

Companies that depend on credit to finance growth

The impact of the credit crunch isn't limited to a few specific sectors of the economy. Any firm, in any industry, that needs to borrow money to continue growing is hurt by the credit crunch. Even more, the industries that are directly impacted can affect other, secondary industries that may not be connected to the credit markets at all. Some (less obvious) examples of companies that have been hit by the credit crunch in one way or another are:

• Home Depot (HD)
• Sprint Nextel (S)
• Toyota Motor (TM)
• FedEx (FDX)

What caused the credit crunch?

Subprime mortgage bust

Many of the subprime mortgages originated since 2000 had adjustable interest rates as opposed to fixed rates. In 2006, an estimated 80% of all subprime loans originated featured "teaser" rates as low as 1% during the introductory period.^[8] When the introductory periods ended, borrowers found themselves with monthly payments that were much higher, often substantially so. One 2007 study stated that monthly payments for 60% of all adjustable-rate mortgages made since 2004 will jump by 25% or more.^[9] With rising payments, more than 24% of subprime loans were either delinquent or in foreclosure by February 2008.^[10] Securities backed by these mortgages, in turn, began to fall in value, hitting investors and the banks that package mortgages into securities.

Mortgage-backed securities and collateralized debt obligations

One of the main features of the subprime boom was investment banks' extensive use of mortgage-backed securities, collateralized debt obligations, and other complex financial instruments to spread risk and free up additional capital to be lent out. Typically, subprime debt was too risky to be considered investment-grade, but the advent of MBSs and CDOs let banks spread the losses from any single default over a large pool of mortgages, presumably minimizing the risk of significant losses for investors. The perception of security, along with the potential for higher returns than on prime-backed securities, made these subprime MBSs very popular among investors, including hedge funds, investment banks, and asset management firms. As subprime defaults rose and banks began posting large losses on subprime-related securities, they had to cut back on their other investments to build up capital and cover the losses. Since financial services firms bankroll much of the economic growth in the U.S., this prevented companies in nearly every industry from obtaining the money they needed to keep growing, spreading the impact of banks' credit losses throughout the economy.

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