Financial markets

30 June 2008

During the period from June 2007 to mid-May 2008, concerns over losses on US subprime mortgage loans escalated into widespread financial stress. What initially appeared to be a contained problem quickly spread across other credit segments and broader financial markets to the point where sizeable parts of the financial system became largely dysfunctional. Surging demand for liquidity, coupled with growing concerns about counterparty risk, led to unprecedented pressures in major interbank markets, while bond yields in advanced industrial economies tumbled as investors sought safe havens amid fears that economic growth would weaken. Equity markets in advanced industrial countries were also weak, with financial shares selling off particularly sharply. A brighter spot was emerging financial markets, which in contrast to previous episodes of broad-based asset market weakness proved to be more resilient than those in the advanced industrial economies.

The financial market turmoil unfolded in six stages, starting in mid-June 2007:

  • a dramatic widening of spreads on subprime mortgage products following large-scale rating downgrades on mortgage-backed securities and the closure of a number of hedge funds with subprime exposure;
  • the extension of the sell-off to a wide variety of credit and other markets from mid-July, including structured products more generally;
  • the expansion of the turmoil into short-term credit and, particularly, interbank money markets from end-July;
  • broader problems for the financial sector from mid-October, including for companies acting as financial guarantors;
  • increasingly dysfunctional markets, against the backdrop of a marked worsening of the US macroeconomic outlook from early 2008, accompanied by rising fears about systemic risks which caused spreads of even the highest-quality assets to move out to unusually wide levels;
  • recovery, except in the interbank term market, in the wake of the Federal Reserve-facilitated takeover of a troubled US investment bank in March 2008.