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Subprime Shock

Global investors were very slow to notice the mounting troubles in the U.S. housing and mortgage markets. After some volatility early in 2007, when the Chinese stock market briefly stumbled, global stock and bond prices rocketed to new highs. But fissures were developing in some esoteric corners of the financial markets, such as the credit default swap market (a market for insurance contracts on bonds—mostly corporate bonds, but also mortgage-backed bonds), but this meant little to all but the handful of investors who traded in them.

But by late spring, the cracks could no longer be ignored. A string of venerable investment banks, including the now-defunct Bear Stearns, announced that some of their hedge funds, which had invested aggressively in mortgage-related securities, were hemorrhaging cash and facing failure. Investors weren’t prepared for the news. Most global stock, bond, and real estate markets were trading near record highs, reflecting investors’ complacent view of the risks involved. As the extent of the financial system’s exposure to subprime mortgages came into relief in the following weeks, these same investors began running for the door. By summer 2007, the subprime financial shock was reverberating across the globe.

Some parts of the market for mortgage-backed securities effectively shut down. Bonds backed by the Federal Housing Administration (which is part of the federal government) and Fannie Mae and Freddie Mac (which at the time were publicly traded companies but have since been nationalized and are now owned by taxpayers) continued to be issued. But banks abruptly stopped issuing other mortgage-backed bonds, especially those backed by subprime loans. At the peak of the boom, such bonds accounted for half of all mortgage originations.

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