Yesterday's 0.5% rate cut is NOT the same as the 0.5% rate cut that occurred in September 2007, despite what Doomers on X want you to believe.
Nuance & proper context are required.
So I asked ChatGPT to provide the nuance...
Read the full breakdown here:
Prompt: "Could you give any history about events leading up to the Fed's 0.5% rate cut in September 2007. Were there any other signs of failure or strain between January 2007 and September 2007?"
ChatGPT Response:
"Between January 2007 and the Federal Reserve's 0.5% rate cut in September 2007, several key events and signs of strain pointed to the mounting pressures in the financial system. This period was marked by cracks in the housing market, rising delinquencies on subprime loans, the early stages of the credit crunch, and the deterioration of financial institutions. These developments set the stage for the Fed's drastic action in September.
Here’s a breakdown of key events and warning signs leading up to the Fed's 0.5% rate cut in September 2007:
1. January 2007 - Housing Market Softens:
By early 2007, there were clear signs that the U.S. housing market was beginning to cool after years of rapid price appreciation. Home sales were declining, and inventories of unsold homes were increasing. Housing prices in many previously booming markets (like Florida, California, and Nevada) were starting to fall.
Subprime Mortgages Under Stress: Delinquencies on subprime mortgages—particularly those issued during the peak of the housing bubble in 2005 and 2006—were on the rise. Borrowers with poor credit histories were finding it increasingly difficult to make payments as adjustable-rate mortgages (ARMs) reset to higher rates.
2. February 2007 - HSBC Warns of Subprime Losses:
In February, HSBC, one of the largest banks in the world, issued a major profit warning due to rising defaults on subprime mortgages in its U.S. portfolio.
HSBC's subprime exposure was seen as an early sign of trouble, and its losses highlighted the risks lurking within the global financial system.
This event marked one of the first large-scale public acknowledgments by a major bank of the growing subprime problem. Investors began to take note of the deteriorating credit quality in the mortgage market, though many still underestimated the broader systemic risks.
3. March 2007 - New Century Financial Files for Bankruptcy:
New Century Financial, one of the largest subprime mortgage lenders in the U.S., filed for bankruptcy in March 2007 after default rates among its borrowers soared. New Century was heavily involved in issuing subprime mortgages, which were bundled into mortgage-backed securities (MBS) and sold to investors.
The bankruptcy of New Century sent shockwaves through the mortgage lending industry and raised concerns about the broader financial system’s exposure to risky lending practices.
Investors in mortgage-backed securities, including banks and hedge funds, were beginning to suffer losses, though the scale of the problem was not yet fully understood.
4. Spring 2007 - Subprime Mortgage Crisis Deepens:
Throughout the spring of 2007, delinquencies and defaults on subprime mortgages continued to increase. Borrowers who had taken out adjustable-rate mortgages (ARMs) were seeing their interest rates reset to much higher levels, causing their monthly payments to spike.
The decline in housing prices accelerated in key markets, particularly in states like California, Nevada, and Florida. As home values fell, homeowners found themselves "underwater" (owing more on their mortgages than their homes were worth), leading to a further increase in foreclosures.
5. June 2007 - Bear Stearns Hedge Funds Collapse:
In June 2007, two highly leveraged hedge funds managed by Bear Stearns, which were heavily invested in mortgage-backed securities (MBS), collapsed. The funds had been exposed to subprime mortgages that were rapidly losing value.
The collapse of these hedge funds was a critical moment in the unfolding financial crisis. It signaled to markets that subprime-related losses were not confined to mortgage lenders but had spread throughout the financial system, including major investment banks.
Though Bear Stearns' collapse wasn’t seen as a systemic event yet, it alerted both regulators and the market to the extent of subprime exposure across major financial institutions. The Federal Reserve and other central banks began to monitor the situation more closely.
6. July 2007 - Credit Rating Agencies Downgrade Subprime Securities:
In July, credit rating agencies Moody’s and Standard & Poor’s downgraded hundreds of subprime mortgage-backed securities (MBS). This was a significant blow because many of these securities had been rated investment-grade (AAA) despite being backed by risky subprime loans.
The downgrades led to a loss of investor confidence in mortgage-backed securities and structured finance products more broadly. Investors began to pull back from the market, leading to a rapid decline in liquidity.
The downgrades and rising defaults led to a sharp contraction in the availability of credit. Banks and investors became wary of lending to each other, fearing that many institutions were holding large amounts of devalued or toxic subprime-related assets.
7. August 2007 - Global Credit Markets Freeze:
By August 2007, global credit markets were seizing up as banks became increasingly reluctant to lend to one another. The interbank lending market, which is crucial for short-term liquidity, nearly froze. Banks were unsure of the extent of other institutions' exposure to toxic subprime mortgage assets, creating widespread fear of hidden losses.
Major financial institutions, including Lehman Brothers and Citigroup, began reporting significant losses tied to subprime mortgages and mortgage-backed securities.
Conclusion & Key Takeaways of Early 2007 Warning Signs:
Rising Subprime Delinquencies: By early 2007, the rise in subprime mortgage defaults signaled trouble ahead, but the full extent of the crisis was not yet appreciated.
The collapse of New Century Financial and Bear Stearns' hedge funds were early warning signs of the systemic risks posed by the subprime mortgage market.
By mid-2007, global credit markets were freezing up as the liquidity crisis spread from subprime mortgage markets to the broader financial system.
By the end of August 2007, the financial system was facing a full-blown credit crisis. Liquidity had dried up, banks were hoarding cash, and the mortgage market was collapsing. Pressure was mounting on the Federal Reserve to take more aggressive action to stabilize the financial system and prevent a broader economic downturn.
The Federal Reserve's decision to cut the federal funds rate by 0.5% on September 18, 2007, was in direct response to the growing strains in the financial system. The rate cut was intended to ease the credit crunch, restore liquidity, and prevent the collapse of major financial institutions.
While the rate cut temporarily boosted market sentiment, it did not address the underlying problems of falling home prices, rising foreclosures, and the mounting losses in the banking system. The crisis continued to deepen, setting the stage for the more severe financial events that would unfold in 2008.
The period from January 2007 to September 2007 was filled with warnings, culminating in the Fed's 0.5% rate cut as the financial crisis began to take shape in earnest. The events during this period exposed the deep vulnerabilities in the financial system that would eventually lead to the Great Recession."
My commentary & conclusions:
Now, given this context, why is this so important?
Because it's a complete contrast vs. the current market conditions.
Of course, the economy isn't perfect... but are we seeing these same types of domestic credit failures at scale?
Simply, no.
In fact, the banking "crisis" of Q1 2023 has been completely mitigated.
Perhaps more failures arise, but we don't have substantive evidence of that yet. As such, I'm not saying to dismiss the potentiality of future risks, but I'm saying that the current conditions are EXTREMELY different than the events that led to the Great Recession.
In 2007, the Fed cut in response to early stage crises.
Today, those crises aren't anywhere to be found.
These are, arguably, the first set of preventative rate cuts that we've seen the Fed do, with Powell citing the intention to prevent further weakening in the labor market.
The Fed isn't trying to accelerate the expansion.
They are trying to elongate the cycle & prolong the resilient & dynamic nature of the U.S. economy, which no longer needs 5% interest rates to combat an inflationary spike.
Said differently, they aren't trying to stimulate.
They are trying to elongate.
They are simply taking their foot off the brakes, which is different than pressing on the gas pedal.
Embrace nuance.
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