John L. Collins
Chair in Finance
Carroll School of Management
324b Fulton Hall
140 Commonwealth Avenue
Chestnut Hill, MA 02467
Liquidity dried up during the financial crisis of 2007-2009. Banks that relied more heavily on core deposit and equity capital financing – stable sources of financing – continued to lend relative to other banks. Banks that held more illiquid assets on their balance sheets, in contrast, increased asset liquidity and reduced lending. Off-balance-sheet liquidity risk materialized on the balance sheet and constrained new credit origination as increased take down demand displaced lending capacity. We conclude that efforts to manage the liquidity crisis by banks led to a decline in credit supply.
Hedge funds using Lehman as prime broker faced a decline in funding liquidity after the September 15, 2008 bankruptcy. We find that stocks held by these Lehman-connected funds experienced greater declines in market liquidity following the bankruptcy than other stocks; the effect was larger for ex ante illiquid stocks and persisted into the beginning of 2009. We find no similar effects surrounding the Bear Stearns failure, suggesting that disruptions surrounding bankruptcy explain the liquidity effects. We conclude that shocks to traders’ funding liquidity reduce the market liquidity of the assets that they trade.
We show that mortgage lenders that concentrate in a few markets invest in more information than diversified lenders. First, concentrated lenders focus on the jumbo-loan market, where returns to information production are highest. Second, they ration credit less and retain more mortgages than diversified lenders. Third, they have higher profits than diversified lenders, their profits vary less systematically, and their stock prices fell much less during the 2007-08 credit crisis. Both across markets and over time, the share of concentrated lending - that is, the share of informed lending - is negatively related to the recent housing price run-up. We therefore conclude that inadequate information production played a key role in the 2001-2008 real estate bubble and crash.
Initial yields on both AAA-rated and non-AAA rated mortgage-backed security (MBS) tranches sold by large issuers are higher than yields on similar tranches sold by small issuers during the market boom years of 2004-2006. Moreover, the prices of MBS sold by large issuers drop more than those sold by small issuers, and the differences are concentrated among tranches issued during 2004-2006. These patterns suggest that investors priced the risk that large issuers received more inflated ratings than small issuers, especially during booming periods.