The 1990s has been a period of an increasing number of financial crises. Moreover these events spread rapidly across the globe, leading to serious concerns regarding the stability of financial markets. For example, the impact of the Mexican peso collapse of 1994 (tequila crisis) was felt in a number of other Latin American countries. The Thai crisis of 1997 (Asian flu) initially impacted the Asian Tigers, and then propagated to other developing regions of the world as far as Latin America. The Russian default in the summer of 1998 (Russian virus) and the subsequent fall of LTCM, resulted in the collapse of numerous financial intermediaries throughout the world.
Furthermore, there was a substantial drop in market liquidity across several unrelated markets, and a movement of investors towards safer and more liquid assets (flight to quality and liquidity). This turmoil in financial markets prompted a coordinated research effort by the central banks of developed nations and the Bank of International Settlements to understand the determinants of market liquidity, and to design preventive policies for the future.
In recent years, there were also a number of domestic shocks that rippled through the markets, causing falling prices, widening spreads, and flight to quality trades. These shocks were market-wide, such as the burst of the internet bubble and the September 11th terrorist attacks, or company-specific (collapses of firms such as WorldCom, Conseco, Enron, and United Airlines). According to Moody’s Default Studies, in 2002 36 issuers with individual debt obligations of at least $1 billion defaulted worldwide. The average real size of default was $1.7 billion, four times the 1983-2001 average. Roughly 34% of the total dollar volume came from firms that held investment-grade status within a year of default.
Furthermore, years 2001 and 2002 yielded the highest percentage of issuer downgrades. A recent example of such an event is the downgrade of General Motors and Ford Motor Cos. to ‘junk’ status. Their troubles had a broad impact on the corporate bond market, widening spreads, and pushing down the yield on Treasury securities. As Steve Rodosky mentions:“It’s obviously a flight to quality trade that we are seeing.” Furthermore, questions remain as to the reasons why we observe these episodes. Tony Crescenzi points out:“The question here is: Is GM a company-specific problem or a market problem?”
