Credit Market Freezes
47 Pages Posted: 22 Jun 2017
Date Written: June 21, 2017
Credit market freezes in which debt issuance declines dramatically and market liquidity evaporates are typically observed during financial crises. In the financial crisis of 2008-09, the structured credit market froze, issuance of corporate bonds declined, and secondary credit markets became highly illiquid. In this paper we analyze liquidity in bond markets during financial crises and compare two main theories of liquidity in markets: (1) asymmetric information and adverse selection, and (2) heterogenous beliefs. Analyzing the 1873 financial crisis as well as the 2008-09 crisis, we find that when bond value deteriorates, bond illiquidity increases, consistent with an adverse selection model of the information sensitivity of debt contracts. While we show that the adverse-selection model of debt liquidity explains a large portion of the rise in illiquidity, we find little support for the hypothesis that opinion dispersion explains illiquidity in financial crises.
Keywords: Credit Market, Financial Crises, Illiquidity
JEL Classification: G01, G12, G23, G32
Suggested Citation: Suggested Citation