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CHAPTER 6
A PP LI CATI O N
The Risk and Term Structure of Interest Rates
117
The Subprime Collapse and the BAA-Treasury Spread
in the United States
Starting in August 2007, the collapse of the subprime mortgage market in the U.S.
led to large losses in American financial institutions (which will be discussed more
extensively in Chapter 9). As a consequence of the subprime collapse, many
investors began to doubt the financial health of corporations with low credit ratings, such as BAA, and even the reliability of the ratings themselves. The perceived
increase in default risk for BAA bonds made them less desirable at any given interest rate, decreased the quantity demanded, and shifted the demand curve for BAA
bonds to the left. As shown in panel (a) of Figure 6-2, the interest rate on
BAA bonds should have risen, which is indeed what happened. Interest rates on
BAA bonds rose by 280 basis points (2.80 percentage points) from 6.63% at the
end of July 2007 to 9.43% at the most virulent stage of the crisis in mid October
2008. But the increase in perceived default risk for BAA bonds after the subprime
collapse made default-free U.S. Treasury bonds relatively more attractive and
shifted the demand curve for these securities to the right an outcome described
by some analysts as a flight to quality. Just as our analysis predicts in Figure 6-2,
interest rates on U.S. Treasury bonds fell by 80 basis points, from 4.78% at the end
of July 2007 to 3.98% in mid-October 2008. The spread between interest rates on
BAA and Treasury bonds rose by 360 basis points from 1.85% before the crisis to
5.45% afterward.
Liquidity
Another attribute of a bond that influences its interest rate is its liquidity. As we