Wonk alert: technical content
One of the many striking features of the recent financial crisis was the sudden “freeze” in the market for the rollover of short-term debt. In this post, based on my paper “Rollover Risk and Market Freezes,” I explain how firms may be unable to borrow overnight against high-quality assets even in the absence of the usual frictions (asymmetric information, adverse selection, or moral hazard) that can cause credit rationing.
The first such market freeze occurred in the summer of 2007. On July 31, two Bear Stearns hedge funds based in the Cayman Islands and invested in subprime assets failed. The following week, more news of problems with subprime assets hit the markets. On August 9, BNP Paribas halted withdrawals from three investment funds and suspended calculation of their net asset values because it could not “fairly” value the funds’ holdings. This announcement appeared to cause investors in asset-backed commercial paper (ABCP), primarily money market funds, to shy away from further financing of ABCP structures. Since many ABCP vehicles had recourse to sponsoring banks that provided them with liquidity and credit enhancements, if ABCP debt could not be rolled over, the sponsoring banks would have to take assets back onto their balance sheets. In that case, given the assets’ illiquidity, the ability of the banks to raise additional financing would be limited too. Money market funds thus faced the risk that the assets underlying ABCP would be liquidated at a loss. This liquidation and rollover risk produced a freeze in the ABCP market, raised concerns about counterparty risk among banks, and caused the Libor to rise. Providing evidence of such a freeze, Gorton and Metrick (2010) show that during 2007-08, the repo haircuts on a variety of assets rose on average from zero in early 2007 to nearly 50 percent in late 2008. Interestingly, while some of the collateralized debt obligations had a 100 percent haircut and thus no secured borrowing capacity at all during the crisis, equities—which are in principle much riskier assets—had only around a 20 percent haircut.
The failure of Bear Stearns in mid-March 2008 offers a second example of a market freeze. (A March 20 Securities and Exchange Commission press release provides an interesting discussion of the account.) As an intrinsic part of its business, Bear Stearns relied on day-to-day, short-term financing through secured borrowing. Beginning late on Monday, March 10, rumors about liquidity problems at Bear Stearns eroded investor confidence in the firm. Even though Bear Stearns continued to have high-quality collateral, counterparties became less willing to enter into collateralized funding arrangements with the firm. This resulted in a crisis of confidence and led to a sharp and continuous fall in Bear Stearns’ liquidity, which caused the near-failure of the firm. Furthermore, even at the time of the firm’s sale, the capital ratio of Bear Stearns was well in excess of the 10 percent level used by the Federal Reserve as its standard for well-capitalized banks. As Chairman Bernanke observed, “Until recently, short-term repos had always been regarded as virtually risk-free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-term unsecured obligations. In March, rapidly unfolding events demonstrated that even repo markets could be severely disrupted when investors believe they might need to sell the underlying collateral in illiquid markets.”
Why the Freezes?
The interesting theoretical question is why liquidity dried up in the repo markets even in the absence of obvious problems of asymmetric information or fears about the value of collateral. The standard result in efficient markets is that the maximum amount of debt that can be obtained, that is, the debt capacity of an asset, is equal to its net present value, or “fundamental” value. However, my aforementioned paper shows that under the conditions described below, which characterize the actual freezes, the debt capacity of an asset is always smaller than its fundamental value, and can be as low as the minimum possible value of the asset:
i) the debt is short-term and needs to be rolled over frequently;
ii) in the event of default by the borrower, the underlying assets are sold to buyers who also use short-term financing, and a (small) liquidation cost is incurred;
iii) information about the quality of the assets arrives slowly relative to the frequency of refinancing the debt.
When information about the quality of the assets arrives slowly relative to the rollover frequency, it is likely that no new (good) information will have arrived by the next time the debt has to be refinanced. The maximum amount the borrower can repay is the maximum amount that can be borrowed at the next rollover date. Since there is a (small) liquidation cost, the best the borrower can do is to issue debt with a face value equal to the next period’s debt capacity, assuming no new information arrives. But this locks the borrower into a situation in which he is forced to act as if his condition will remain the same forever. In fact, his situation is somewhat worse, because there is always the possibility of bad news arriving, which will force him to default and realize the liquidation cost. These two facts—the need to set the face value of debt low and the possibility of default if bad news about the asset arrives—guarantee that the debt capacity is always less than the fundamental value. In fact, the difference between the fundamental value and the debt capacity can be very large, because the fundamental value reflects the substantial probability of good news arriving, whereas the debt capacity ignores this upside potential from the arrival of good news. Thus, a small change in the fundamental value of the assets may be accompanied by a dramatic fall in the debt capacity, resulting in a market freeze—a situation similar to the freeze that occurred in the secured short-term debt markets during the recent crisis.
One of the important lessons from the recent crisis is that while secured short-term debt is a major source of funding, at times it can be subject to rollover risk. As Chairman Bernanke also observed, future liquidity planning for financial institutions must take into account the possibility of a sudden loss of substantial amounts of secured financing.
The views expressed in this blog are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).