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How Debt Markets have Malfunctioned in the Crisis

  • Arvind Krishnamurthy
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    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.

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    File URL: http://www.nber.org/papers/w15542.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15542.

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    Date of creation: Nov 2009
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    Publication status: published as Arvind Krishnamurthy, 2010. "How Debt Markets Have Malfunctioned in the Crisis," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 3-28, Winter.
    Handle: RePEc:nbr:nberwo:15542
    Note: AP CF ME
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    1. 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.
    2. Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.
    3. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
    4. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
    5. Brunnermeier, Markus K & Pedersen, Lasse Heje, 2007. "Market Liquidity and Funding Liquidity," CEPR Discussion Papers 6179, C.E.P.R. Discussion Papers.
    6. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
    7. Greenwood, Robin & Vayanos, Dimitri, 2008. "Bond Supply and Excess Bond Returns," CEPR Discussion Papers 6694, C.E.P.R. Discussion Papers.
    8. Ricardo J. Caballero & Arvind Krishnamurthy, 2007. "Collective Risk Management in a Flight to Quality Episode," NBER Working Papers 12896, 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. repec:oup:rfinst:v:25:y::i:6:p:1799-1843 is not listed on IDEAS
    11. Nicolae B. Garleanu & Lasse H. Pedersen, 2007. "Liquidity and Risk Management," NBER Working Papers 12887, National Bureau of Economic Research, Inc.
    12. Dimitri Vayanos, 2004. "Flight to Quality, Flight to Liquidity, and the Pricing of Risk," NBER Working Papers 10327, National Bureau of Economic Research, Inc.
    13. Adriano Rampini & Andrea Eisfeldt, 2005. "Financing Shortfalls and the Value of Aggregate Liquidity," 2005 Meeting Papers 889, Society for Economic Dynamics.
    14. Annette Vissing-Jorgensen & Arvind Krishnamurthy, 2008. "The Aggregate Demand for Treasury Debt," 2008 Meeting Papers 713, Society for Economic Dynamics.
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