Economic Report President

attributed to the lesser liquidity of private issues at a time whenheightened uncertainty created larger liquidity premiums; we returnto this issue shortly. In addition, less risk-averse investors (such ashedge funds, discussed later in this chapter) faced more cautiouslenders during this period, which reduced their ability to purchaseriskier or less liquid securities.Market conditions also worsened along several other dimensions.Issuance of new debt dropped precipitously, with public offerings ofnonfinancial corporate bonds falling roughly by half between July andSeptember. In the high-yield sector, issuance virtually ceased inAugust and September. Dealers were reluctant to manage new offeringsinto the fall, probably because of the heightened uncertainty infinancial markets and greater difficulty in placing new securities.Some firms substituted bank loans for financing in the securities market,and business lending by banks boomed. However, banks were notimmune to the rising economic uncertainty, and they tightened theirbusiness loan standards and terms.A further worrisome development was the increasing illiquidity ofdebt markets, especially after mid-September. Bid-ask spreadswidened substantially, and dealers were less willing to enter intolarge transactions at posted rates. The price of liquidity climbed, too.So-called on-the-run Treasury securities are the most recently issuedof a given maturity, and they are traded much more actively than offthe-runsecurities. Because of this greater liquidity, on-the-run issuesusually offer yields that are a few basis points below off-the-run yieldsof similar maturity, but this gap widened considerably for 30-yearbonds in late September. In addition, the yield spread between theTreasury’s on-the-run conventional debt and its less liquid inflationindexeddebt fell much more sharply during this period than didsurvey measures of inflation.Equity prices slumped as well. Between July 17 and August 31, boththe S&P 500 and the NASDAQ lost about one-fifth of their value,falling a little below their levels at the beginning of the year. The Russell2000 index of small-capitalization stocks had lagged behind othermajor indexes since the spring, and by the end of August it stood nearly23 percent below its value at the beginning of the year. Equityissuance by nonfinancial corporations declined sharply in late summeras well.These gyrations in financial markets took a toll on financial institutions.Share prices of money-center banks (which include some of thelargest commercial banks) and investment banks fell much moresharply than the broad equity indexes, in the face of rising concernabout exposure to emerging markets, the quality of loan portfolios, andpossible losses from securities trading activities. Nevertheless, theunderlying strength of the commercial banking system—whichenjoyed generally high profits, low delinquency and charge-off rates,61