How Debt Markets Have Malfunctioned
Transcript of 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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Debt Markets and Financial InstitutionsDebt Markets and Financial Institutions
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Debt Markets and Financial InstitutionsDebt Markets and Financial Institutions
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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;