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MARCH TO AUGUST : SYSTEMIC RISK CONCERNS
stopped the market in CDOs. In addition, the credit rating agencies’ decision to issue
a negative outlook on the monoline insurers had jolted everyone, because they guar-
anteed hundreds of billions of dollars in structured products. As we have seen, when
their credit ratings were downgraded, the value of all the assets they guaranteed, in-
cluding municipal bonds and other securities, necessarily lost some value in the mar-
ket, a drop that affected the conservative institutional investors in those markets. In
the vernacular of Wall Street, this outcome is the knock-on effect; in the vernacular
of Main Street, the domino effect; in the vernacular of the Fed, systemic risk.
BANKS: “THE MARKETS WERE REALLY, REALLY DICEY”
By the fall of , signs of strain were beginning to emerge among the commercial
banks. In the fourth quarter of , commercial banks’ earnings declined to a -
year low, driven by write-downs on mortgage-backed securities and CDOs and by
record provisions for future loan losses, as borrowers had increasing difficulty meet-
ing their mortgage payments—and even greater difficulty was anticipated. The net
charge-off rate—the ratio of failed loans to total loans—rose to its highest level since
, when the economy was coming out of the post-/ recession. Earnings con-
tinued to decline in —at first, more for big banks than small banks, in part be-
cause of write-downs related to their investment banking–type activities, including
the packaging of mortgage-backed securities, CDOs, and collateralized loan obliga-
tions. Declines in market values required banks to write down the value of their
holdings of these securities. As previously noted, several of the largest banks had also
provided support to off-balance-sheet activities, such as money market funds and
commercial paper programs, bringing additional assets onto their balance sheets—
assets that were losing value fast. Supervisors had begun to downgrade the ratings of
many smaller banks in response to their high exposures in residential real estate con-
struction, an industry that virtually went out of business as financing dried up in
mid-. By the end of , the FDIC had banks, mainly smaller ones, on its
“problem list”; their combined assets totaled . billion. (When large banks
started to be downgraded, in early , they stayed off the FDIC’s problem list, as
supervisors rarely give the largest institutions the lowest ratings.)
The market for nonconforming mortgage securitizations (those backed by mort-
gages that did not meet Fannie Mae’s or Freddie Mac’s underwriting or mortgage size
guidelines) had also vanished in the fourth quarter of . Not only did these non-
conforming loans prove harder to sell, but they also proved less attractive to keep on
balance sheet, as house price forecasts looked increasingly grim. Already, house
prices had fallen about for the year, depending on the measure. In the first quarter
of , real estate loans in the banking sector showed the smallest quarterly increase
since . IndyMac reported a decline in loan production for that quarter
from a year earlier, because it had stopped making nonconforming loans. Washing-
ton Mutual, the largest thrift, discontinued all remaining lending through its sub-
prime mortgage channel in April .
But those actions could not reduce the subprime and Alt-A exposure that these
