How did the credit crunch become a global financial crisis?
As the credit crunch escalated, many CDOs found themselves stuck with various tranches of MBS debt, especially the highest risk tranches, which they had not yet placed or were unable to place as subprime foreclosure rates around the country escalated. Commercial and investment banks were forced to write down billions of subprime debt. As the U.S. economy slipped into recession, banks also started to set aside billions for credit-card debt and other consumer loans they feared would go bad. The credit rating firms—Moody’s, S&P, and Fitch—lowered their ratings on many CDOs after recognizing that the models they had used to evaluate the risk of the various tranches were mis-specified. Additionally, the credit rating firms downgraded many MBS, especially those containing subprime mortgages, as foreclosures around the country increased. An unsustainable problem arose for bond insurers who sold credit default swap (CDS) contracts and the banks that purchased this credit insurance. As the bond insurers got hit with claims from bank-sponsored SIVs as the MBS debt in their portfolios defaulted, the credit rating agencies required the insurers to put up more collateral with the counterparties who held the other side of the CDSs, which put stress on their capital base and prompted credit-rating downgrades, which in turn triggered more margin calls. If big bond insurers, such as American International Group (AIG) failed, the banks that relied on the insurance protection would be forced to write down even more mortgage-backed debt which would further erode their Tier I Core capital bases. By September 2008, a worldwide flight to quality investments—primarily short term U.S. Treasury Securities—ensued. The demand for safety was so great, at one point in November 2008, the one-month U.S. Treasury bill was yielding only one basis point. The modern day equivalent of a ‘bank run’ was operating in full force and many financial institutions could not survive.