Finance & Accounting Policy Apr 1, 2011

Debt Mar­kets Dur­ing the Crisis

Fail­ure to see the big pic­ture led to a breakdown

Based on the research of

Arvind Krishnamurthy

The finan­cial cri­sis that pro­voked the Great Reces­sion had severe effects on debt mar­kets, includ­ing the cor­po­rate bond and mort­gage-backed secu­ri­ties mar­kets. The effects includ­ed a huge pre­mi­um on liq­uid­i­ty, the loss of cap­i­tal, and ris­ing risk for coun­ter­par­ties, the part­ners in debt mar­ket transactions.

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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.”

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.” 

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, “ 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. “ 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.”

Relat­ed read­ing on Kel­logg Insight

Liq­uid­i­ty Rules: Man­age inno­va­tion or risk repeat­ing history

Reces­sion-fight­ing Serendip­i­ty: Well-timed gov­ern­ment spend­ing can blunt eco­nom­ic contractions

About the Writer

Peter Gwynne is a freelance writer based in Sandwich, Mass.

About the Research

Krishnamurthy, Arvind. 2010. How debt markets have malfunctioned in the crisis. Journal of Economic Perspectives 24(1):3-28.

Read the original

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