Professional Documents
Culture Documents
in the Crisis
Arvind Krishnamurthy
Journal of Economic Perspectives—Volume 24, Number 1—Winter 2010—Pages 3–28
Introduction
The financial crisis that began in 2007 is
especially a crisis in debt markets;
Debt instruments:
◦ Loans (intended to be hold till maturity);
◦ Securities (ABS, MBS, CDO …)
“structured finance” instruments (multiple tranches)
Spiral effect:
◦ Risk capital falls, causing institutional risk aversion to
rise and asset values to fall, causing risk capital to fall
further, and so on.
Repo Financing and Haircuts
In practice, financial institutions raise equity capital
infrequently;
A repo agreement is a loan that is collateralized by
financial securities;
Lenders typically set the haircut high enough so that they
need not do any detailed analysis of the underlying
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 attractive—say, relative to
placing money in a large time deposit in a bank—because
it is over-collateralized.
Repo Financing and Haircuts
Examples:
◦ Interest Rate Swap Spread;
◦ GNMA Mortgage-Backed Security;
Interest Rate Swap Spread
Externalities;
The government has little (or no) demand for liquidity;
The government can internalize these externalities in
their decisions, one can offer a rationale for why the
government should inject capital in the financial sector;