A look back at the 2008 financial crisis: The disconnect between credit and market risks

This study examines the impact of credit and market risks in the wake of the 2008 financial crisis. In the seven-year period before the collapse of the housing market in 2007, credit risk premiums rose steadily in an apparent reflection of the mounting household debt. However, the equity market failed to take into account the rising default risk that should have served as a signal of the impending disaster. As a result, home prices and stock market values continued to increase and attain record levels. This bullish market behavior was largely driven by low levels of market risk, as evidenced by unusually low levels of implied volatility. To investigate this anomaly, a decomposition of the forecast error variance of stock market returns was performed over an extended period. Two outcomes of the empirical analysis are of note. The first is that prior to the crisis, the equity market showed minimal response to innovations in the credit market. However, in the longer term, the yield on short-term U.S. government obligations had a pronounced effect. The second is that in the period since the crisis began, the credit risk indicator has become particularly preeminent, suggesting a more risk-averse equity market.