The Subprime Collapse and the Baa Treasury Spread
Starting in August 2007, the collapse of the subprime mortgage market led to large losses in financial institutions (which we will discuss more extensively in Chapter 8). 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 5.2, 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 5.2, interest rates on 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.