How Debt Markets Have Malfunctioned In The Crisis

This paper explains how debt markets have malfunctioned in the crisis, with deleterious consequences for the real economy. The author begins with a quick overview of debt markets. The author then discusses 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. The author documents the remarkable rise in the premium that investors placed on liquidity during the crisis.