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How Debt Markets Have Malfunctioned in the Crisis

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  • Arvind Krishnamurthy
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    Abstract

    The financial crisis that began in 2007 is especially a crisis in debt markets. A full understanding of what happened in the financial crisis requires investigation into the plumbing of debt markets. During a financial crisis, when funds often cannot be raised easily or quickly, the fundamental values for certain assets can become separated for 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. After a quick overview of debt markets, I 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 will document the remarkable rise in the premium that investors placed on liquidity during the crisis. Next, I will 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 will 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.

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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.24.1.3
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    Bibliographic Info

    Article provided by American Economic Association in its journal Journal of Economic Perspectives.

    Volume (Year): 24 (2010)
    Issue (Month): 1 (Winter)
    Pages: 3-28

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    Handle: RePEc:aea:jecper:v:24:y:2010:i:1:p:3-28

    Note: DOI: 10.1257/jep.24.1.3
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    1. Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.
    2. Dimitri Vayanos, 2004. "Flight to Quality, Flight to Liquidity, and the Pricing of Risk," NBER Working Papers 10327, National Bureau of Economic Research, Inc.
    3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    4. Brunnermeier, Markus K & Pedersen, Lasse Heje, 2007. "Market Liquidity and Funding Liquidity," CEPR Discussion Papers 6179, C.E.P.R. Discussion Papers.
    5. Xavier Gabaix & Arvind Krishnamurthy & Olivier Vigneron, 2007. "Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market," Journal of Finance, American Finance Association, vol. 62(2), pages 557-595, 04.
    6. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
    7. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
    8. Robin Greenwood & Dimitri Vayanos, 2008. "Bond Supply and Excess Bond Returns," NBER Working Papers 13806, National Bureau of Economic Research, Inc.
    9. Krishnamurthy, Arvind, 2002. "The bond/old-bond spread," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 463-506.
    10. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
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