LIQUIDITY CRISES

In 1994 and again in 1998, fixed income markets, especially derivatives and mortgage derivatives, suffered terrible liquidity crises, which at the time seemed to threaten the stability of the whole financial system. Though we shall see that economists have had trouble precisely defining liquidity, the general features of the liquidity crises can be succinctly described. In both episodes one saw the following:

1. There was a price crash in defaultable assets, especially for the riskiest assets, but without a commensurate increase in subsequent defaults.

2. These effects spilled over many markets, such as high-risk corporate bonds and mortgages, even though the risks of default are probably not correlated between the markets.

3. There was a huge income loss for the most adventurous buyers (e.g., hedge funds purchasing derivatives).

4. There was an increase in the spread between more “liquid” and less “liquid” securities (like off-the-run Treasuries and on-the-run Treasuries), even though the assets had the same probability of default. Thus default spreads and liquidity spreads both increased.

5. The margin requirements on borrowing were raised.

6. Borrowing decreased.

Another crucial observation is that the crises did not seem to be driven by changes in the riskless interest rate. In 1994, Treasury interest rates were rising before the crisis, whereas in 1998 they were falling. Moreover, when the margin requirements on borrowing were raised, the interest rate charged remained virtually the same.