How Debt Markets have Malfunctioned in the Crisis

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.