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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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    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
    Date of revision:
    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
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    1. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
    2. 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.
    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. Nicolae B. Garleanu & Lasse H. Pedersen, 2007. "Liquidity and Risk Management," NBER Working Papers 12887, National Bureau of Economic Research, Inc.
    5. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    6. Adriano Rampini & Andrea Eisfeldt, 2005. "Financing Shortfalls and the Value of Aggregate Liquidity," 2005 Meeting Papers 889, Society for Economic Dynamics.
    7. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
    8. Dimitri Vayanos & Robin Greenwood, 2008. "Bond Supply and Excess Bond Returns," FMG Discussion Papers dp607, Financial Markets Group.
    9. Gary Gorton & Andrew Metrick, 2010. "Securitized Banking and the Run on Repo," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
    10. Dimitri Vayanos, 2004. "Flight to Quality, Flight to Liquidity, and the Pricing of Risk," NBER Working Papers 10327, National Bureau of Economic Research, Inc.
    11. Annette Vissing-Jorgensen & Arvind Krishnamurthy, 2008. "The Aggregate Demand for Treasury Debt," 2008 Meeting Papers 713, Society for Economic Dynamics.
    12. Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.
    13. Krishnamurthy, Arvind, 2002. "The bond/old-bond spread," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 463-506.
    14. repec:oup:rfinst:v:25:y::i:6:p:1799-1843 is not listed on IDEAS
    15. Isabelle Huault & V. Perret & S. Charreire-Petit, 2007. "Management," Post-Print halshs-00337676, HAL.
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