How Debt Markets Have Malfunctioned

8/8/2019 How Debt Markets Have Malfunctioned

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How Debt Markets Have MalfunctionedHow Debt Markets Have Malfunctioned

in the Crisisin the Crisis

Arvind Krishnamurthy

Journal of Economic PerspectivesVolume 24, Number 1Winter 2010Pages 328


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IntroductionIntroduction The financial crisis that began in 2007 is

especially a crisis in debt markets;

The Dow Jones eventually fell to 6,600 by

March 2009;

A full understanding of what happened in the

financial crisis requires inquiring into theplumbing of debt markets.


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IntroductionIntroduction Trades in debt markets are predominantly made

by financial institutionslike banks, hedge funds,and insurance companiesrather than

households;

If funds can be raised fairly easily and quickly,

debt markets should function fairly smoothly.

But during a financial crisis, funds often cannotbe raised easily or quickly;


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IntroductionIntroduction In such a setting, the fundamental values for

certain assets can become separated for a timefrom 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;


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OverviewOverview Debt markets and financial institutions;

Crucial areas in all debt markets decisions: Risk capital and risk aversion;

Repo financing and haircuts;

Counterparty risk; Liquidity;

Price effects on debt securities:

Interest rate swap spread;

GNMA Mortgage-backed security

Government policy to plug the leaks;


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less liquidity and a higher cost for finance

can reinforce each other in a contagiousspiral;

rise in the remium that investors laced

on liquidity during the crisis;

discuss briefly four steps that the Federal

Reserve took to ease the crisis;


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Debt Markets and Financial InstitutionsDebt Markets and Financial Institutions

Debt instruments:

Loans (intended to be hold till maturity); Securities (ABS, MBS, CDO )

structured finance instruments (multiple tranches)

Financial institutions (banks, insurance

companies, hedge funds, brokers and dealers,

and government-sponsored enterprises like

Fannie Mae and Freddie Mac)


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Three Considerations in Every DebtThree Considerations in Every Debt

Market PurchaseMarket Purchase

Risk capital and institutional risk aversion

Less risk capital leads to greater institutional riskaversion;

Banks must have equity capital commensurate to the

financial distress sufficiently small;

For other financial institutions, decision making at the

level of a trader is often formulated in terms of a value-

at-risk constraint;


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RiskRisk capital and institutional risk aversioncapital and institutional risk aversion

During the crisis, financial institutions have taken

enormous losses in their risk capital ($985billion);

The cumulative reported losses from the 2nd

quarter of 2007 to the 2nd quarter of 2009 is

$971 billion; total capital raised is $732 billion,

with a good part of this due to the U.S. Treasurycapital injection plan (TARP);


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Risk capital and institutional risk aversionRisk capital and institutional risk aversion


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Risk capital and institutional risk aversionRisk capital and institutional risk aversion

Spiral effect:

Risk capital falls, causing institutional risk aversion torise and asset values to fall, causing risk capital to fall

further, and so on.


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Repo Financing and HaircutsRepo Financing and Haircuts

In practice, financial institutions raise equity capital

infrequently;

A repo agreement is a loan that is collateralized byfinancial securities;

Lenders typically set the haircut high enough so that they

need not do an detailed anal sis of the underl in

collateral; BIS estimate that the repo market in 2007 was roughly

$10 trillion in size (Hordahl and King (2008)).

To the cash investor, repo is attractivesay, relative to

placing money in a large time deposit in a bankbecause

it is over-collateralized.


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Repo Financing and HaircutsRepo Financing and Haircuts

When repo lenders determine haircuts, they have two

main considerations:

the probability of a borrower defaulting on the repo loan;

for these short-term loans, it is usually quite small.

the recovery value when liquidating the collateral in the

secondary market if default occurs;

This has played a dramatic role in the crisis. The secondary market

for mortgage-backed securities is less liquid than the secondarymarket for Treasuries.


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Counterparty RiskCounterparty Risk As counterparty risk grows, financial institutions reduce their

reliance on repo, but then have to shift to slower financing

arrangements.

The trading decisions of financial institutions are affected, andwith that, the rices and li uidit of the traded debt

instruments suffer.

Interest rate swap.

Increasing counterparty risk triggers demands for greater

collateral and reduces the volume of transactions ininterest rate swaps.

Credit default swap;


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Counterparty RiskCounterparty Risk AIG went from being a high-quality AA-rated insurer to

near-bankruptcy in one week;

AIG was the counterparty on a large volume of swaps

with other financial institutions;

The U.S. Treasury purchased equity capital in financialinstitutions in October, thus reducing the probability of

bankruptcy;

Goldman Sachs and Morgan Stanley became commercial

banks;


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LiquidityLiquidity Declining liquidity reflects two considerations:

Financial institutions that provide the secondary

market in debt instruments reduce their purchasing;

many investors become more averse to owning

,

investments in liquid assets;


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LiquidityLiquidity Some more facts:

the price of the illiquid asset has fallen in the crisis

relative to the price of the liquid asset;

a shorter-term security is more liquid, so a desire for

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securities over longer-term ones;

Liquidity and the maturity

a three-month loan is less liquid than an overnight loan;


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Failure of Monetary policyFailure of Monetary policy Monetary policy only directly controls the overnight rate.

In the liquid market, market expectations and arbitrage

forces transmit policy changes in the overnight rate to

longer-term rates, such as the three-month interest rate,

thereby affecting the relevant cost of borrowing for firms

and households. In the illiquid environment of the crisis, this transmission

has been impaired, reducing the effectiveness of

monetary policy.


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Price Effects on Debt SecuritiesPrice Effects on Debt Securities Limit of arbitrage. Shleifer and Vishny (1997);

The lack of liquidity and purchasers in debt markets can

mean that arbitrage fails to perform well, and fundamental

rices can diver e from market rices.

Examples:

Interest Rate Swap Spread;

GNMA Mortgage-Backed Security;


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Interest Rate Swap SpreadInterest Rate Swap Spread

Interest rate swaps transactions outstanding was

$403 trillion (The International Swap Dealers Association reports

in 2008);

eliminate the negative swap spread? (figure 8);

There was little risk capital in the marketplace;

The repo requires a haircut, which was larger than usual

Counterparty risk was high


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GNMA MortgageGNMA Mortgage--Backed SecurityBacked Security


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Government Policy to Plug the LeaksGovernment Policy to Plug the Leaks Many academics and policymakers think that asset

prices during the crisis have deviated significantly from

fundamental values and that this deviation is part of theproblem affecting financial institutions;

Fall of the market price w.r.t. the fundamental priceleads to larger capital losses for banks.

binding capital requirements

reduction in bank lending

deeper recession.

To overcome the limits-of-arbitrage problems


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Government Policy to Plug the LeaksGovernment Policy to Plug the Leaks Troubled Asset Relief Program (TARP) in fall 2008,

which eventually took the form of the government

purchasing equity capital in over 600 commercialbanks nationwide;

Commercial banks are only a subset of the financial institutions.

Alteration of the traditional Federal Reserve discount

window

facility to lend to primary bond dealers (for example, Goldman,

Sachs, Morgan Stanley, and other noncommercial banks)following the failure of Bear Stearns.

broaden the class of debt instruments that the Fed accepts as

collateral;


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Government Policy to Plug the LeaksGovernment Policy to Plug the Leaks

The Federal Reserve and Treasury have initiated a Term Asset-

Backed Lending Facility (TALF). TALF offers repo loans against the collateral of newly issued asset-

backed securities, for a loan maturity of up to three years.

the Fed has offered longer-term, 28-day discount window loans.

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have been purchasing MBSs since the end of 2008 (FederalReserve, 2008). By the end of the first quarter of 2010, the Federal Reserve will

purchase a total of $1.25 trillion of MBSs issued by government-

sponsored enterprises.

This initiative is an effort to purchase directly assets that may be

trading below fundamental value.


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ConclusionConclusion

In the risk-capital context, falling asset prices decreaserisk capital, increasing financial institutions risk aversionand further reducing asset prices;

In the haircut context, falling liquidity raises haircuts,reducin re o activit and tradin , which further reduces

liquidity;

Externalities;

The government has little (or no) demand for liquidity;

The government can internalize these externalities intheir decisions, one can offer a rationale for why thegovernment should inject capital in the financial sector;

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How Debt Markets Have Malfunctioned