THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 239

CHAPTER 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