Chicago Booth BUSF 35150 - How Debt Markets have Malfunctioned in the Crisis

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1 How Debt Markets have Malfunctioned in the Crisis 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. *Kellogg School of Management, Northwestern University, and National Bureau of Economic Research. Email: [email protected]. I am grateful to Tobias Adrian, Markus Brunnermeier, Ricardo Caballero, Jan Eberly, Mike Fishman, Gary Gorton, Bengt Holmstrom, Ravi Jagannathan, Jonathan Parker, Todd Pulvino, and Asani Sarkar for their comments. I also thank the editors of the Journal of Economic Perspectives, Timothy Taylor, David Autor and Chad Jones, for their comments. This article was prepared for the Winter 2010 issue of the Journal of Economic Perspectives.2 The financial crisis that began in 2007 is especially a crisis in debt markets. For example, the stock market peaked in October 2007, with the Dow Jones Industrial Average near 14,000, and was still near 12,000 in August 2008. While the Dow Jones eventually fell to 6600 by March 2009, most of that fall happened in late 2008. However, problems in debt markets like the mortgage-backed securities market had been in full swing since August of 2007. A full understanding of what happened in the financial crisis requires inquiring into the plumbing of debt markets. Trades in debt markets are predominantly made by financial institutions – like banks, hedge funds, and insurance companies– rather than households. One key feature of markets in debt instruments is that whenever a trader wishes to make an investment, it must first raise money, either through a sale of existing financial assets, or by borrowing funds from another party. If funds can be raised fairly easily and quickly, debt markets should function fairly smoothly. But during a financial crisis, funds often cannot be raised easily or quickly. In such a setting, the fundamental values for certain assets can become separated from a time from market prices, with consequences that can echo into the real economy. This article will explain in concrete ways how debt markets can malfunction, 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'll document the remarkable rise in the premium that investors placed on liquidity during the crisis. Next, I'll show how these issues caused debt markets to break down: indeed, 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'll 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. It is important to keep in mind throughout this discussion that a “financial institution” is not just a traditional commercial bank. A number of different intermediaries do not take deposits directly from households, but in many ways functionally behave like banks in debt markets, even though they are not labeled banks. I use the term “financial institution” to refer to all of these entities, including insurance companies, hedge funds, brokers and dealers, and government-sponsored enterprises like Fannie Mae and Freddie Mac.3 DEBT MARKETS AND FINANCIAL INSTITUTIONS Debt instruments can be usefully divided into loans and securities. The key distinction is that a “loan” is an investment that a financial institution has made and intends to hold to maturity. However, a security is an asset that is backed by a pool of loans originated by some financial institution, but which has subsequently been sold by the financial institution and is being held by another entity. A mortgage-backed security, where the backing is a pool of residential loans, is the typical security. Table 1 provides a sense of the type and size of the debt markets that have been at the center of the financial crisis. The categories under “loans” are familiar ones: three categories of mortgage loans differentiated by the riskiness of the borrower (from more to less riskiness, subprime, Alt-A and prime), along with commercial real estate and corporate loans. Under the listing of securities, all instruments with the exception of corporate bonds are “structured finance” instruments in which a pool of underlying loans backs possibly multiple tranches of securities, distinguished by seniority. Typically, investors in junior tranches would take all the losses before those in higher mezzanine or even higher senior tranches would take any losses. The most complex of these structured investments are the collateralized debt obligations where the assets backing the securitization are themselves the junior or mezzanine tranches of other securitizations. Under the category of asset-backed securities, the underlying loans are non-mortgage lending, like car loans or credit card loans. Collateralized loan obligations are backed by corporate loans. Mortgage-backed securities are backed by either residential or commercial real estate loans. The total in Table 1 across both loans and securities is $18.64 trillion. The debt instruments in Table 1 are held by a number of


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Chicago Booth BUSF 35150 - How Debt Markets have Malfunctioned in the Crisis

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