THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 239

CHAPTER 9

Financial Crises and the Subprime Meltdown

207

TED Spread
(percentage point)
6.00
5.00
4.00
3.00
2.00
1.00
0.00

2007

2008
Date

FIGURE 9-2

Treasury Bill-to-Eurodollar Rate (TED) Spread

The TED spread is a good indicator of liquidity in the interbank market
Source: www.federalreserve.gov/releases/h1S/data.htm

100 years when Northern Rock, which had relied on wholesale short-term borrowing rather than deposits for its funding, collapsed in September 2008.
In Canada, the early symptom of the U.S. subprime crisis was the freezing of
the asset-backed commercial paper (ABCP) market in August 2007. It caused a

sharp decrease in liquidity in short-term Canadian credit markets, including the
overnight interbank market and the overnight repurchase market. In order to
restore confidence and liquidity in the ABCP market, and prevent significant writeoffs for banks that would have reduced their capital and raised concerns about
their solvency, market participants reached an agreement, known as the Montreal
Accord, to restructure the frozen ABCP market and minimize the costs to the
Canadian taxpayer (see the FYI box, Canada s Asset-Backed Commercial Paper
Saga, for more details).

Banks
Balance
Sheets
Deteriorate

The decline in U.S. housing prices, which now accelerated, led to rising defaults
on mortgages. As a result, the value of mortgage-backed securities and CDOs collapsed, leading to ever-larger write-downs at banks and other financial institutions.
The balance sheets of these institutions deteriorated because of the losses from
their holdings of these securities and because many of these institutions had to
take back onto their balance sheets some of the structured investment vehicles
(SIVs) they had sponsored. Structured investment vehicles are similar to CDOs
in that they pay out cash flows from pools of assets such as mortgages; instead of
issuing long-term debt as in CDOs, they issued asset-backed commercial paper.
With weaker balance sheets, these banks and other financial institutions began to
deleverage, selling off assets and restricting the availability of credit to both households and businesses. With no one else able to step in to collect information and
make loans, adverse selection and moral hazard problems increased in the credit
markets, leading to a slowing of the U.S. economy and rising unemployment
levels.