Debt Markets During the Crisis

On one hand, the size of the impact hardly surprised the experts. “Financial crises seem much more prominent in debt markets than in equity markets, because investors in debt markets are essentially playing with borrowed money,” says Arvind Krishnamurthy, a professor of finance at the Kellogg School of Management. Debt markets are most actively traded by banks, hedge funds, insurance companies, and similar institutions. On the other hand, diagnosing exactly why the debt markets faltered so spectacularly has proved difficult. Several researchers and industry insiders have identified parts of the puzzle, but until now no one has elicited a broad theme to describe what went wrong.

A review article by Krishnamurthy has filled that gap. The article assembles the evidence to reveal a complete picture of what went wrong. “Many people in the profession, including me, have given talks about the issue,” Krishnamurthy says. “But I don’t think anyone has written it up as I do.”

The Historical Precedent

The crisis in the debt markets should not have come as a complete surprise to industry professionals. “The patterns that played out in this crisis were actually similar to patterns we’ve had in other crises—although nothing exact. So from that standpoint the financial sector should have been prepared to deal with fallout from the crisis,” Krishnamurthy says. “But the scale of this crisis was much bigger than anything we have seen in the past 25 years.”

Plainly, it is important to recognize historical precedent. “I want readers to understand the patterns of disruptions in this financial crisis and, by example, in financial crises more generally,” Krishnamurthy says. “I also want to educate them on the policy response. There’s a lot of confusion about what the Fed has done. This analysis can speak to many of the things the Fed did and how its actions made sense.”

His message has already made an impact in business schools. “A lot of faculty members have used it in their teaching to explain aspects of the financial crisis and the Fed’s response to the crisis,” Krishnamurthy says.

Two Critical Factors

The write-up identifies two critical factors in the crisis: First, feedback effects meant that, as Krishnamurthy notes in his paper, “less liquidity and a higher cost for finance can reinforce each other in a contagious spiral.” Added to that was “the remarkable rise in the premium that investors placed on liquidity.” As a result, the paper indicates, markets went topsy-turvy and the crisis had an impact on financial segments far removed from the “toxic” subprime mortgages that lay at the root of the problem. The paper also points out the steps that the Federal Reserve took to ease the crisis, each geared to a specific fault that arose.

Krishnamurthy prepared his paper in response to an invitation from editors of the Journal of Economic Perspectives, a general publication for the entire economics profession, including members with relatively little knowledge of debt markets and how they could falter. “I’m bringing together threads from my own and other people’s work to explain what happened. I put the magnifying glass on the financial intermediary sector—collections of entities that are very active traders in the debt markets,” he relates. “During the period from October 2008 to spring 2009, financial markets were incredibly dysfunctional. That was at core what I was trying to understand.”

As his raw material, Krishnamurthy used public data to shed light on a variety of factors that were central to debt markets during the crisis. Those factors included risk capital and risk aversion, the collateralized loans called “repo” agreements, the “haircuts” that represent down payments for the loans, and the counterparty risks assumed by partners in debt market transactions.

The data point to a vicious cycle. As Krishnamurthy describes it, “[A] decline in asset values reduces risk capital, raises haircuts, and increases counterparty risk. In turn, purchasers in debt markets will be less eager to buy. There is a flight to more liquid and shorter-maturity debt instruments. In some cases, disfavored debt markets can essentially cease to exist for a time.”

Leaks in the Plumbing

Overall, Krishnamurthy concludes that what he calls “the basic financial plumbing that enforces fundamental value relationships in debt markets” became impaired during the financial crisis. He also finds circumstantial evidence that in certain debt markets the market value of holdings deviated significantly from their inherent value.

The data revealed one bright spot: the reactions of the government and the Federal Reserve. Initiatives such as the Troubled Asset Relief Program, expansion of loans by the Fed, the Term Asset-Backed Landing Facility for loans collateralized by newly issued securities, and the purchase of mortgage-backed securities, Krishnamurthy concluded, helped to plug the leaks in the system.

Krishnamurthy believes that the financial industry and its regulators failed to see the entirety of what was happening during the crisis. “Traders and regulators all understood their little corner of the market, but nobody assembled the pieces together,” he explains, adding that regulatory risk controls failed because the regulators failed to see the broad picture.

That inability to see the broad picture also played out in financial institutions. “There are risk control checks and balances in any firm, starting with a senior risk management committee and going down to the head trader in a particular asset class. In every one of these steps there was an under-pricing and under-appreciation of the risk,” Krishnamurthy explains. “Say I understand feedback in my own market but I don’t know about how other factors could affect my markets. That’s the failure of risk management.”

His paper also includes recommendations—and a warning. “[P]rudential policy should be geared toward requiring firms to carry higher capital levels…Similarly, I have argued that the U.S. government can provide liquidity during crises because it uniquely has no liquidity needs,” Krishnamurthy states. More generally, he notes, the experience indicates the need for regulation that will create a market structure that’s inherently less prone to crises. “However,” he concludes, “if the national debt increases rapidly, the government may one day find itself in the position that its creditworthiness is reduced to the point it too will demand liquidity. This sobering thought offers a further reminder of the policy challenges we face.”

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