This paper is a descriptive account of the behavior of debt markets during the crisis, with a focus on how this behavior can tell us about the underlying frictions faced by financial institutions.

Amplification Mechanisms in Liquidity Crises

I describe two amplifications mechanisms that operate during liquidity crises and discuss the scope for central bank policies during crises as well as preventive policies in advance of crises. The first mechanism works through asset prices and balance sheets. A negative shock to the balance sheets of asset-holders causes them to liquidate assets, lowering prices, further deteriorating balance sheets, culminating in a crisis. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations lead agents to become uncertain about their investments causing them to disengage from markets and increase their demand for liquidity. This behavior leads to a loss of liquidity and a crisis.

A Model of Capital and Crises (joint with Z. He)

We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during financial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates. In a dynamic context, we show that aversion to drops in intermediary capital can generate a two-factor asset pricing model with a role for both a market factor and a liquidity factor.

Intermediary Asset Pricing (joint with Z. He): major revision October 2008

We present a model to study the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face a constraint on raising equity capital. When the constraint binds, so that intermediaries' equity capital is scarce, risk premia rise to reflect the capital scarcity. We calibrate the model and show that it does well in matching two aspects of crises: the nonlinearity of risk premia during crisis episodes; and, the speed of adjustment in risk premia from a crisis back to pre-crisis levels. We use the model to quantitatively evaluate the effectiveness of a variety of central bank policies, including reducing intermediaries' borrowing costs, infusing equity capital, and directly intervening in distressed asset markets. All of these policies are effective in aiding the recovery from a crisis. Infusing equity capital into intermediaries is particularly effective because it attacks the equity capital constraint that is at the root of the crisis in our model.

The Aggregate Demand for Treasury Debt (joint with A. Vissing-Jorgensen): major revision August 2008

We show that the US Debt/GDP ratio is negatively correlated with the yield spread between corporate bonds and Treasury bonds, controlling for default risk on corporate bonds. The corporate bond spread reflects a convenience yield that investors attribute to Treasury debt. Changes in Treasury supply trace out convenience demand. At the current supply of Treasuries, the convenience yield is around 100 bps. The superior trading liquidity of Treasuries accounts for 50 bps while the surety of Treasuries confers an additional 50 bps of convenience yield. Regulatory demanders of Treasuries, including foreign central banks, are central drivers of the convenience yield.

Liquidity and Interest Rates (Slides from talk at the AEA meetings)

Light Reading:

On Fundamental Value and the Limits to Arbitrage(11/08)

Liquidity Benefits of the Bailout Proposal(9/08)

Short commentary on current credit crisis (8/07) , Link to Economist Article about the paper

Older Papers:

Fiscal Policy and Financial Depth (joint with R. Caballero)

Liquidity Illusion: On the Risks of Sterilization(joint with R. Caballero)

International Liquidity Management: Sterilization Policy in Illiquid Financial Markets(joint with R. Caballero)

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Last Revised: September 3, 2008