How Debt Markets Have Malfunctioned in the Crisis

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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