Impact of Credit Crisis on Market Liquidity and IPOs

The credit crisis led to a significant impact on the liquidity and trading activities in the market, resulting in lower overall activities and caused inactivity. The US Federal Reserve responded by reducing interest rates to improve market liquidity, which had a negative effect on the economy. This resulted in a marked downgrade in economic outlook and increased downside risks regarding inflation and output. The credit crisis also had a significant impact on Initial Public Offerings (IPOs), causing investors to lose confidence in the equity market and resulting in a crash in stock prices. As a result, new companies were hesitant to issue IPOs, leading to a reduction in opportunities for growth and capital raising.

Running Head: IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITY
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IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITY
Credit Crisis
The credit crisis is a major threat to the economy. It is a situation where the
availability of lending gets tightened due to the various activities. It will have an impact on
the short-term debt, long-term debt and the day to day operations of the bank. These credit
crises are popularly known as the credit crunch, in this case, the amount that is available for
companies to obtain a loan for the commercial purposes gets tightened, and there will be less
supply of funds (FRBSF, 2012). On the other hand, there will be a reduction in the amount of
credit available for the retail customers, and it creates more crunch to the money supply.
The credit crisis is mainly used for referring the crisis that took place during 2007 and
2008 in the United States. The main reason for terming the great recession as credit crisis is
that it has created a catastrophic effect on the entire economy of the country and the rest of
the world. Having an understanding of the reasons for such crisis is essential. The credit crisis
is triggered when the event of non-repayment of loan is increasing in the market. In other
words, when the default rate of the borrowers is increasing it is the initiation phase of the
credit crisis, and it is the primary reason for the 2007-08 crisis (FRBSF, 2012).
In the US, due to the housing bubble, many sub-prime loans were disbursed at the
higher rate of interest on the mortgage-backed securities and asset-backed securities vehicles.
These instruments were more famous and highly demanded in the market by the investors as
they were providing a higher rate of interest to the people. Many investors invested in various
tranches of these instruments (FRBSF, 2012). These instruments had various tranches with
each tranche having their identifying characteristics like the rate of interest, level of risk,
repayment method, etc. Based on the requirement and as per the risk tolerance level and
amount of investment that can be made by the institutions and individual investors
investment were made on these instruments.
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IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITY
These instruments were not transparent in disclosing the information about their
investment portfolio to the investors and provided a loan to subprime customers with poor
credit rating and repayment ability. These borrowers were unable to repay the borrowed
amount resulting in huge amount of default. It resulted in the loss of investment by the
investors who invested in the MBS and ABS. It resulted in fall of huge institutions and the
created great recession.
The consequences of the credit crisis are negative yields in Treasury bill trade. Risk
premium soars in corporate bonds, the worst performance of the stock market, increase in
illiquidity and increase in unemployment, etc. The credit crisis will have a direct impact on
both the bond market and stock market. The credit crisis will result in lack of liquidity in the
debt market that further adds more trouble to the entire economic system.
Lack of Liquidity in Debt Market and Credit Crisis
Lack of liquidity takes place when the amount of transaction taking place is lower that
is there is a lower level of purchase and sales of bonds or lower level of trading activities
taking place in the bond market (Adrian, Fleming, Shachar, & Vogt, 2016). Debt market
consists of both Treasury bonds and corporate bonds. During the good economic time, more
people have a better inflow of money, and they make more focus on generating a better return
on investment. The MBS and ABS were at a peak during this period.
More investors began to invest in all these assets and various other mutual funds with
an intention to generate a higher return on investment when compared to the bond market
(Adrian, Fleming, Shachar, & Vogt, 2016). It is the time when the emerging economies were
providing attractive bond interest rate to sell their bonds and raise more capital when
compared to the advanced economies. It resulted in more focus on the bond market that was
providing lower yield on the investment due to the best available alternatives.
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IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITY
Eventually, when the credit crisis hit the market, it created more shock to the entire
economy, and it affected the bond markets too (Adrian, Fleming, Shachar, & Vogt, 2016).
More investors faced huge loss due to their investment decision of investing in more risky
assets and began to focus on making more investment in the risk-free asset. It resulted in
more switch to the treasury bond investment. When the level of investment on the treasury
instruments was increasing, it was creating more pressure on the US economy, and it requires
them to reduce the interest rates.
On the other hand, many companies in the US were adversely affected by the
recession and investors were reluctant to invest in the corporate bonds even though they were
providing higher risk premium due to the risk associated with them (Adrian, Fleming,
Shachar, & Vogt, 2016). When the amount of investment in the government securities was
increasing, it caused more pressure on the debt management of the country as they are
responsible for repaying the amount to the investors as per the maturity.
It resulted in negative yield and lowering of the transaction in the debt market by
lowering the interest rate to nearly zero making the investment avenue more unattractive.
When the rate of return on the investment is nil, and they are expected to provide negative
yield it reduces the investor attraction over the bonds, and it resulted in lower level of trade in
the bond market and it resulted in lack of liquidity in the market (Adrian, Fleming, Shachar,
& Vogt, 2016). People were not ready to buy the bonds, and at the same time, people were
focusing on squaring off their position to guard themselves against the adversities.
It resulted in increasing more volatility in the market without any considerable
changes in the prices that caused more pressure to the liquidity in the bond market (Adrian,
Fleming, Shachar, & Vogt, 2016). The bond market is not the best destination for protecting
the people from the recession. They are not the destination for protecting the people from the
stock market crash. There is a detailed way of looking at them is essential to understand the
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reason for illiquidity in the market. When credit crises hit the market, it affects businesses
and individuals.
More attention is paid to the businesses as saving the companies are most important as
it has a direct impact over the industrial output and employment of the country (Adrian,
Fleming, Shachar, & Vogt, 2016). Saving industries are critical part of the government.
Federal Reserve understood the growing demand for the money in the economy to provide
the required and essential bailout to the large enterprises to overcome the recession impact
and for stabilizing their business. It increased the demand for the cash to the government.
Federal Reserve decided to print the notes, but there is a restriction for printing the
notes as they cannot be printed and circulated in the market without any basis. Federal
reserve captured the trend over the demand for the government bonds among investors
irrespective of the lower rate of return (Adrian, Fleming, Shachar, & Vogt, 2016). To
materialize the available opportunity, Federal Reserve began to purchase the outstanding
bonds in the market at large level. When purchasing the bonds, the government has to repay
the sellers. It made the government to easily supply the money to the seller by purchasing the
bonds from the open market and crediting the money.
The aggressive purchase of the bonds was one of the main reasons for the illiquidity
in the market. It resulted in pumping in the required money supply into the market and axing
the bond supply and circulation in the market. It resulted in reducing the availability of the
bond in the market for trading that resulted in poor trading. Similarly, more investors were
focusing on the risk-free investment resulted in negative yield that made the bond market
further illiquid.
Bonds are essential for the banks to provide support to the collateralized transactions
and for active participation in the swap market (Adrian, Fleming, Shachar, & Vogt, 2016).
Due to credit crisis banks were aggressive in the market participation to ensure that they are
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not posting a further loss that will paralyze their operations and would result in non-
repayment of their obligatory dues to the investors on time. Due to the requirement of the
money supply by the businesses, Federal Reserve dried up the availability of bonds from the
bond market.
This reduction in the bond availability in the market posed a great problem for the
bankers in handling their collateral transactions and curtailed their participation in the swap
transactions. It barricaded their participation in various major transactions and caused more
illiquidity in the market. Changes in the economic condition and shocks in the market will
affect bond markets too.
Debt Market Become Inactive
Debt markets are actively used by the bankers, hedge funders, insurance companies
and other financial institutions. The credit crisis has a direct impact on these businesses when
compared to the other businesses that have an impact on the debt market trading activities
(Krishnamurthy, 2009). During the credit crisis period, many investors prefer to hold more
funds in the liquid assets when compared to the illiquid assets that result in slowing down the
debt market activities. The credit crisis resulted in falling risk capital, rising repo haircuts and
increase in the counterparty risks by the financial institutions.
Financial institutions play an important role in the secondary market in dealing with
debt instruments, and they were the primary reason for the lower level of purchasing and
training activities in the debt market (Krishnamurthy, 2009). It is evident that the price of
illiquid assets always falls during the credit crisis period when compared to the more liquid
assets during the same time. The Federal National Mortgage Associations (FNMA) issue
bonds that are similar to the Treasury bonds for managing their financial activities.
The FNMA bonds are less liquid when compared to the US Treasury bonds that are
guaranteed by the US government (Krishnamurthy, 2009). The FNMA was taking over by
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IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITY
the Treasury bonds resulting in boosting the liquidity of the bonds, and it resulted in
increasing the spread basis points. FNMA was again given the option to reprivatize their
bonds. When a bond is privatized, they have a lower level of liquidity when compared to the
bonds that carry the guarantee from the government.
There were more private institutions bonds and corporate bonds in the market besides
the government bonds that were perceived to be illiquid and investors were not willing to
continue their trading with these bonds. It is one of the reasons for the lower level of liquidity
in the debt market. The Federal funds overnight index swap rate did not change during the
time of crisis when compared to the Treasury bond rates mainly indicating that there were no
much changes in the federal fund policy rates during that period when compared to the
Treasury bond rates.
Short-term debts are less liquid when compared to the long-term debt. Maturity is the
main influencing factor for the liquidity of the company. For an institution relying on the
overnight financing is riskier when compared to the long-term financing, therefore, they are
highly inclined towards the long-term funding (Krishnamurthy, 2009). During crisis period, it
is essential to pay close attention to the interbank borrowing rate that is interbank rates were
higher than the overnight federal fund rate that created more trouble to the financial
institutions and banks in managing their liquidity position and was contributing for flatter
debt market.
The debt market became inactive due to the higher costs that were causing more
trouble to these institutions in managing the requirements (Krishnamurthy, 2009). Investors
began to make the higher premium for the liquidity reasons that was adding more pressure to
the liquid assets. It resulted in the market to be topsy-turvy. The credit crisis resulted in
market dysfunction resulted in more trouble to various financial markets of the country.
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It is important to pay attention to the vicious circle that is present in the market that is
causing more trouble to the debt market. The decrease in the asset value will reduce the
overall risk associated with the capital, and it will increase the repo haircuts, and at the same
time, it will increase the counterparty risks (Krishnamurthy, 2009). All these factors cause a
negative impact on the debt market trading that it will reduce the motivation for debt market
participation and lower level of purchase in debt. It is the main reason for causing
inactiveness in the debt market.
There will more demand for shorter maturing instruments that have better and higher
liquidity when compared to long-term assets (Krishnamurthy, 2009). It adds more pressure on
the short-term assets as investors have poor confidence over the performance of the
instrument in long-term. Financial plumbing causes more issues to the fundamental value
relationships in the debt market. During the crisis, there was more deviation in the value of
the instruments when compared to their inherent value.
Government policies, reactions and Federal Reserve policies for collateralizing the
loans with the new security instruments and the purchase of MBS by them were the main
reason for the leak in the system (Krishnamurthy, 2009). There was a weakness in the
regulators to capture the entire problem and in understanding the causes of the problem
before forming and rolling out various policies. There was a failure in control over the
regulatory risks that resulted in causing illiquidity to the debt market.
Various initiatives were taken by the government to reduce the holding over risky
capital and to hold less risky capital. These transformation and changes resulted in focusing
more less risky capital that caused more inactivity in the debt market which was highly used
by the institutions in meeting their requirements (Krishnamurthy, 2009). When there is less
focus on low-risk capital and business management, there will be a lower requirement for
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managing the liquidity and trading activities. It will result in lower level of overall activities
in the market and caused inactivity.
Interest Rate Impact
As mentioned earlier during the credit crisis investors focuses on obtaining more
liquid assets when compared to the illiquid assets, and they increase the premium for the
liquid assets. Especially, those assets with shorter maturity are subject more volatility when
compared to the long-term assets in the market. US Federal Reserve mainly focuses on
maintaining their interest rates between 2% and 5% for maintaining a healthy economy and
smooth operation of the country (Krishnamurthy, 2009).
Credit crisis results in lowest interest rate in the history to improve the liquidity of the
market. The federal reserve always responds well to the changes in the market to ensure that
they are cushioning the movement in the market and to create more value for the economy
(Krishnamurthy, 2009). During 2007, where there was a huge bubble in the housing market
the federal reserve began to reduce the interest rate to manage the increasing borrowing from
the people and institutions.
During 2007 period there was more amount of borrowings, and there was a huge
demand for more funds by the individuals and the financial institutions (Krishnamurthy,
2009). It demanded the federal reserve to pull down their interest rate so that they will be in a
position to fund the growing demands of borrowing and it will provide stimulus to the
economy and will not cause more trouble to the borrowers for repaying their debt obligations.
When the great recession hit, that is credit crisis began there was more pressure on the federal
reserves to reduce the interest rate further.
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Image Source: Rudebusch, 2009.
The main reason for reducing the interest rate to the lowest was to provide facilities to
the institutions and companies to borrow funds at a lower rate and to manage their business
operations effectively. During the financial crisis, there were more focus and demand for the
government bonds. The government cannot maintain higher interest rate as more investors
will pump in more funds to these bonds that will increase the government debt. The
government requires more funds to provide a bailout to the companies and stabilize the
economy but at the same time cannot afford for higher interest rate due to the poor economic
condition.
It resulted in federal reserve to reduce the interest rate in the market. The government
has to issue more bonds to raise the funds that they can route to towards bailouts, and they
cannot handle more pressure due to higher interest rate. It resulted in lower and even negative
interest rates. Indicating that there is a requirement for money supply, but the rate at which
these funds are required are at 0% or even below than the 0%. It is mainly to boost the
economy and not to create more trouble to the current economic condition of the country. If
the federal rates are lower, it will result in companies to issue their bonds at lower rates that
can provide a better alternative for them in effectively managing their capital requirements.
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This reduction in the interest rate was the main signal about the marked downgrade in
the outlook of the economy and indication about the increase in the downside risks regarding
inflation and the output. It indicates that the economic performance will be poor and there
will be a lower level of industrial output. It indicates that the economy in the future will
require more stimulus to stabilize their industry and condition as individuals, financial
institutions and corporations cannot afford to pay higher interest rate towards their borrowing
and the level of borrowing and financial transactions will be at bay.
Initial Public Offering
The initial public offering is those where a company is issuing their shares newly into
market to raise the required capital from the market and to provide support to their business
growth through the huge infusion of capital. It will require the companies to issue their shares
in the market as a primary issue after evaluating the value of the company. It will require the
investors to participate in the issue actively and purchase the stocks through the IPO issue
made by the company.
For an IPO to become successful in the market, there is a requirement for a favorable
economic condition that is if the economic condition is good then investors will have
confidence over the market and will have funds to invest in the new company. On the other
hand, if the economic conditions are poor then it will result in investors to have poor
confidence in the new business, and they will be hesitant to invest in the new company. In
case of the credit crisis, it completely swept the stock market.
It resulted in the significant fall and crash in the stock market, that is stock index fell
badly, and all the stocks listed in the market performed poorly and were valued lower.
Investors lost entire confidence in the equity market, and they are not ready to take any risk
by investing in well-established enterprises. These crises created negative effect over all the
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industries and companies listed in the exchange. The rate of unemployment spiked high due
to the recession and many companies defaulted.
It created more negative impression about the equity market in the minds of the
investors. Investors were not ready to take any risk especially related to their investment
because they do not want to lose their investment further. IPO is riskier when compared to
the other modes of investment. Mostly investors with sound knowledge about the business
and industry and are willing to take risks invests in these companies as they are expected to
provide huge return on investment.
Image Source: Wilmer Hale, 2009.
The negative impression created in the minds of people about the equity investment
and consequences of investing in risky assets or ventures made them reluctant to provide any
positive response to these new ventures. When investors are not ready to make any
investment in the IPO, it will demand the companies to undervalue their stock price so that
they can attract investors to invest in their companies. New business is participating in IPO to
raise more funds for the growth and development of their business, and they will not be ready
for any undervaluation.
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Undervaluation will offset the purpose of IPO for the companies as they cannot
potentially raise the required funds. Therefore, companies were not ready to participate in the
IPO as it will not be profitable for them to issue their shares in the market due to the poor
performance of the equity market and undervaluation of the stocks. Investors were reluctant
to trade in the stock market due to the risks and that curtail the opportunities for the new
companies to raise the required capital and to fund their growing requirements. Thus, credit
crisis created a completely negative impression about the entire market and reduced the
opportunity for the new companies to grow and raise the capital.
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References
Adrian, T., Fleming, M., Shachar, O., & Vogt, E. (2016). Market Liquidity after the
Financial Crisis. Retrieved from Federal Reserve Bank of New York website:
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr796.pdf
FRBSF. (2012, May 14). Liquidity Risk and Credit in the Financial Crisis. Retrieved from
https://www.frbsf.org/economic-research/publications/economic-letter/2012/may/
liquidity-risk-credit-financial-crisis/
Krishnamurthy, A. (2009). How Debt Markets have Malfunctioned in the Crisis. Journal of
Economic Perspectives, 24(1). doi:10.3386/w15542
Rudebusch, G. D. (2009, May 22). The Fed’s Monetary Policy Response to the Current
Crisis. Retrieved from
https://www.frbsf.org/economic-research/publications/economic-letter/2009/may/fed-
monetary-policy-crisis/
Wilmer Hale. (2009). 2009 IPO Report. Retrieved from IPO Guide Book website:
https://www.ipoguidebook.com/files/upload/2009_IPO_Report.pdf
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