Professor Paul Palley's
          Economics Seminars

Events that led to the credit crunch or credit freeze that started in 2007 have exposed the importance of the bond market. A credit crunch is a dramatic unwillingness on the part of banks to lend and unwillingness or inability of businesses and individuals to borrow, A credit crunch often causes or worsens recessions, or at best only weakens the rate of economic growth. This raises several issues including the basic question; what is a bond? It further requires us to consider the relationship between bond prices and interest rates. Finally, the events starting in 2007 require us to consider a particular type of bond, the mortgage backed security.

At the most basic level, a bond is an IOU. All bonds, whether they are corporate, municipal, or Treasury bonds, should be viewed in this way. In effect the buyer of the bond loans money to the issuer of the bond. In exchange the buyer expects to receive interest payments and get the principal or the face amount of the bond repaid. At the same time, bond buyers face two risks. The first is credit risk or the risk associated with the possibility that the bond issuer will not be able to make expected interest payments or the value of the principal at the end of the term of the bond. Clearly, Treasury bonds are not risky as the U.S. government will be able to honor its responsibilities. Until recently, bonds backed by mortgages were assumed to be not as risk free as U.S. treasuries, but still relatively very safe.

The other risk faced by bond buyers is interest-rate risk. The reason is as follows. As interest rates increase bond prices go down. On the other hand, as interest rates decrease bond prices go up. This reverse relationship can be explained through the following example. Suppose you were to buy a 5-year bond paying its face value of $1,000 that pays a 6% annual interest rate. This means the buyer receives interest payments equal to $60 per year. Then suppose that after you bought this bond a similar 5-year bond is issued with a face value of $1,000, but it pays a 7% annual interest rate or the buyer would receive interest payments equal to $70 per year. The result is logical, the buyer of the 5-year bond with a face value of $1,000 that pays a 6% annual interest rate would have been better off if they had bought the bond paying 7%. The value of this $1,000 bond that pays 6% would decline. If someone were to try to sell the bond paying 6% they would see that the value of their bond had declined.

This brings us to the problems that started in 2007 with mortgage backed securities. These are bonds which are backed by mortgages. It had been expected that these bonds would not be as risk-free as U.S. treasuries, but would still be relatively safe. After all, historically very few people had defaulted on their mortgages. As we now know, the underlying security of many mortgages was compromised by poor due diligence efforts by lenders, speculative home buyers, and home buyers who did not understand the mortgages they committed to or had willingly misled the lender. The result is higher perceived risk which would imply higher interest rates and this led to declines in the value of mortgage backed securities.

The surprising thing about the crises in the mortgage backed security market that emerged in 2007 is the number of banks, investment banks, and institutional investors who were exposed to problems in this market. Buyers of these bonds made these investments because mortgage backed by securities were perceived to be relatively safe and they paid a higher interest rate than U.S. treasuries with the same term. Still, these mortgage bond securities only make sense as an investment with a term longer than one or two years if you assume that the housing market will continue to be relatively strong and interest rates will continue to be relatively stable. The strength of the housing market is needed to promote stable home values (not typically a problem until the housing market bubble burst starting in 2006) and to promote stable supply and demand conditions in the mortgage market. Secondly, in the long-run purchasers of mortgage backed securities lose when interest rates increase and when interest rates decrease. First, when mortgage rates increase the value of mortgage backed securities decline for the same reasons described in my example above. Secondly, when mortgage rates decline borrowers can refinance and as result the underlying value of the mortgages backing the mortgage backed security declines.