Working Paper: NBER ID: w15542
Authors: Arvind Krishnamurthy
Abstract: This article explains how debt markets have malfunctioned in the crisis, with deleterious consequences for the real economy. I begin with a quick overview of debt markets. I then discuss three areas that are crucial in all debt markets decisions: risk capital and risk aversion, repo financing and haircuts, and counterparty risk. In each of these areas, feedback effects can arise, so that less liquidity and a higher cost for finance can reinforce each other in a contagious spiral. I document the remarkable rise in the premium that investors placed on liquidity during the crisis. Next, I show how these issues caused debt markets to break down: fundamental values and market values seemed to diverge across several markets and products that were far removed from the "toxic" subprime mortgage assets at the root of the crisis. Finally, I discuss briefly four steps that the Federal Reserve took to ease the crisis, and how each was geared to a specific systemic fault that arose during the crisis.
Keywords: debt markets; financial crisis; liquidity; risk capital; repo financing
JEL Codes: E43; E44; E52; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Decline in risk capital among financial institutions (G21) | Increased risk aversion (D81) |
| Increased risk aversion (D81) | Reduced willingness to engage in debt market transactions (G19) |
| Reduced willingness to engage in debt market transactions (G19) | Decreased liquidity (G33) |
| Decreased liquidity (G33) | Reduced asset prices (G19) |
| Reduced asset prices (G19) | Additional declines in risk capital (G32) |
| Rising repo haircuts (E49) | Increased counterparty risk (F65) |
| Increased counterparty risk (F65) | Exacerbated liquidity issues in debt markets (F65) |
| Higher haircuts (F31) | Diminished ability to finance trades (G19) |
| Diminished ability to finance trades (G19) | Contraction in market activity (E32) |
| Rise in perceived risk (D81) | Reduction in reliance on repo agreements (E49) |
| Reduction in reliance on repo agreements (E49) | Further impeding liquidity (G33) |