The Role of Institutional Investors in Propagating the Crisis of 2007-2008

Abstract

Using a novel data set of institutional investors’ bond holdings, we study a transmission mechanism that explains the contagion of the financial crisis of 2007-2008 from the securitized bond market to the corporate bond market. We argue that the crisis shock was propagated by the behavior of institutional investors, which held both securitized bonds and corporate bonds and had to liquidate portions of their portfolios due to their liquidity needs. When securitized bonds became “toxic” in August 2007, mutual funds facing liquidity needs retained the now illiquid securitized bonds and sold their corporate bond holdings. Funds with negative contemporaneous flows, high turnover, or high flow volatility liquidated greater portions of their corporate bond holdings than others. The average mutual fund tended to sell more junk bonds than investment-grade bonds. Yield spreads and bond sales went up by more for corporate bonds whose pre-crisis bondholders’ portfolios were more heavily exposed to securitized bonds, compared to same-issuer corporate bonds held by unexposed mutual funds. In contrast, insurance companies sold little regardless of their exposure to securitized bonds as long as they were above the minimum capital ratio threshold. These findings suggest that mutual funds with high liquidity needs that were left with exposure to now illiquid securitized bonds at the onset of the crisis played a role in propagating the crisis from securitized bonds to corporate bonds.

Keywords: crisis transmission, securitized debt, corporate bonds

JEL Classification: G1, G2