Those of us who were paying attention during the financial crisis of 2007 to 2009 likely remember the word “contagion” being thrown around a lot, as companies and entire business sectors that had no obvious connection to the subprime mortgage industry suddenly found themselves unwelcome in the traditional credit markets.
It was as though the financial services industry had contracted some terrible disease, and passed it on to the non-financial sector. And while many commentators spoke learnedly of contagion, few articulated a real explanation for how the crisis spread as far and as fast as it did.
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A new paper by Hadiye Aslan of Georgia State University and Praveen Kumar of the University of Houston takes an almost epidemiological approach to investigating the causes of lenders’ and investors’ sudden loss of confidence in the creditworthiness of companies that had little likely connection to the subprime lending crisis.
The study, available here, finds that much of the reason for the loss of confidence in non-financial firms was a result not of investors suddenly concerned about invisible connections between them and the subprime mortgage market, but a measurable drop in the value of their corporate bonds, caused by bondholders’ need to raise cash quickly.
As the subprime mortgage market crashed, large institutional investors and bond funds were faced with a two-pronged problem. Regulatory requirements forced some to rebalance their holdings with lower-risk investments, and worried investors demanded to redeem their shares for cash.
This created a need for liquid funds, and at that point in time, subprime mortgage holdings were anything but liquid. That meant that troubled institutional investors had to sell off other holdings at what Alan and Kumar characterize as “fire sale” prices. This created the impression of doubt in the value of the corporate bonds, as purchasers faced with a market glut, drove prices down.
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The ‘infection,’ having been passed to firms not associated with the real estate markets, continued to do damage by raising interest rates on corporate debt and making companies less willing to invest. It also made it more difficult for them to react to moves by competitors who had the liquid assets needed to adopt new strategies or products.
“We find that fire sales of corporate bonds did indeed have statistically and economically negative effects on the investment activity and economic performance of issuing firms,” they wrote. “Moreover, issuing firms facing large and “deep-pockets” rivals [all things equal] lost market shares and obtained lower price-cost markups in their product markets, while their major suppliers and customers also exhibit significantly lower investment activity compared with matched firms not vertically linked to firms exposed to bond fire sales.”
The paper’s findings won’t change the way most people remember the financial crisis, but for those who watch such things closely, it provides a nuanced look at what “contagion” really meant that hasn’t been available until now.
