The following is the S&P 500 chart in 2007.
*Read the entire history of the U.S. stock market here.
Although subprime mortgages were clearly in trouble by early 2006, the subprime mortgage index only started to fall by late-2006. This was because only banks that sold these mortgage bonds could quote prices. They deliberately misquoted these prices (prices were above real value) until they could no longer misquote prices because the discrepancy was too obvious.
The financial sector was clearly in trouble by the beginning of January 2007. On January 31, ABX (subprime mortgage index) fell more than 1 point in a single day. Prior to this, the ABX had slowly grinded down from 100 to 93. The downwards trend was now picking up pace.
February 8, 2007: HSBC announced a surprising loss on its subprime mortgage loans. HSBC announced in March that it would sell its entire subprime mortgage loans portfolio. This savvy move is why HSBC was not at risk of failure during the 2008 financial crisis.
By early-spring 2007, the subprime bond market had strengthened a bit. This bounce caused Bernake to state that “the subprime market has bottomed” on March 7. However, historical analysts would have known that credit quality always gets better in March and April because people get their tax refunds (so they pay off more of their debt). The subprime market bounced not because its fundamentals improved but because of tax related reasons.
April 2, 2007: New Century (biggest subprime mortgage lender) went bankrupt because too many of its lenders defaulted.
June 14 2007: Bear Sterns Asset Management (a CDO hedge fund owned by Bear Sterns) shut down after declaring heavy losses on subprime mortgages.
After the spring 2007 bounce, the subprime mortgage bond market started to fall again in early June, this time for good.
In July, Merill Lynch released a very good earnings report but admitted losses from subprime mortgage bonds. This is important because prior to this released, investors did not know that banks were keeping these toxic assets for their own books. They thought that the banks merely package these bonds and sold them to naive investors. Now it was clear that banks owned some of the garbage they were selling. So if the mortgage market fell, banks would suffer big losses.
To create a bond, a bank would pool many mortgages together and cut them into tranches. The highest tranche would be the safest mortgages with the lowest interest rates, the bottom tranches would be the riskiest mortgages with the highest interest rates. Since investors didn’t want the highest tranches (lowest interest rates), the issuing bank often kept the highest tranches for themselves. When a financial tsunami like 2008 hit, every single tranche faced defaults.
The Federal Reserve injected liquidity into the financial markets in August.
August 31, 2007: At Jackson Hole, Bernake announced that the Fed would cut rates for the first time in years by 0.5% at the September meeting. This pushed the S&P to a new all-time high. However, the all-time high was short lived. It demonstrates that in the medium-long run the Federal Reserve’s policies have very little impact on the markets.
By November, Standard and Poors (ratings agency) had downgraded Bearn Sterns’ credit rating from AA to A.
The U.S. economy in 2007 faced 2 main problems: a collapsing housing market and falling auto sales. However, the stock market always lags the real-time state of the economy. By “state of the economy”, we are not referring to GDP. We are referring to the dozens of other economic data that are released every month. GDP lags and is a very volatile indicator.
By the end of 2007, the financial sector was down more than 20% even though the S&P 500 was only down 6.5%.