Edited by Adrian R. Bell, Chris Brooks and Marcel Prokopczuk
Chapter 11: Testing for contagion: the impact of US structured markets on international financial markets
The United States (US) subprime crisis, driven by the decline in US house prices and the subsequent threats of mortgage defaults, has had a significant (negative) impact on financial markets. From 2006 onwards, threats of US mortgage loan defaults heightened and prices of collateralized asset-backed securities (ABS) containing subprime mortgages and collateralized debt obligations (CDO) tumbled, all of which resulted in an almost complete halt in trading and disruption in the normal price discovery process. Furthermore, financial markets suffered from significant recessionary expectations as both market and funding liquidity shrunk within the financial system. Caruana and Kodres (2008) point out that the average maturity of US short-term asset-backed commercial paper (ABCP) shortened by six days with outstanding ABCP declines amounting to approximately $300 billion from August 2007 onwards. As the liquidity of both money markets and structured credit markets withered, the ability of banking institutions to raise external funds was severely impaired. Meanwhile, the level of interbank lending also declined as evidenced by the widening of LIBOR overnight index swap spreads. These national effects evolved into a global (and catastrophic) context, and was followed by a series of collapses and bailouts of renowned financial institutions, most notably, Lehman Brothers, Merrill Lynch, Washington Mutual, AIG, Fannie Mae and Freddie Mac. All of these effects led to a prolonged period of global economic recession characterized by frequent injections of liquidity and rescue actions by central banks and government authorities.
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