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Explain how shifts in short-term wholesale funding markets fed the crisis, systemic risk effects included.

FRM® Part I · Foundations of Risk Management · Anatomy of the Great Financial Crisis of 2007-2009 · FRM1.FR.10.e

The idea

Before the crisis many banks, conduits and securities dealers financed long-term assets with short-term wholesale funding: asset-backed commercial paper, repurchase agreements and borrowing from money market funds. Such funding must be rolled over often. A repo haircut is the cash not lent against collateral. Haircut = (collateral value − cash lent) ÷ collateral value. Maximum leverage = 1 ÷ haircut. When doubts rose, from August 2007 and sharply after Lehman, lenders refused to roll paper and raised haircuts. Borrowers had to sell assets, which pushed prices lower and triggered further margin calls. This was a loss and margin spiral. The LIBOR-OIS spread widened because banks distrusted one another. Systemic risk arose because forced selling hurt institutions that had never held subprime assets. Expect questions on haircuts and spirals.

Formulas

Repo haircut

haircut = (C − L) ÷ C

C
the market value of the collateral
L
the cash lent against it

Maximum leverage is about 1 ÷ haircut, so a rise in haircuts forces sales even with prices unchanged. Selling assets also removes collateral, which makes the required sale larger.

A practice question

From the question bank, with the reason each wrong option is wrong.

Many conduits, structured investment vehicles and dealers funded themselves with short-term wholesale instruments. Which vulnerability did this create?

  1. Credit mismatch: short-term assets financed with perpetual equity capitalWhy not: Reverses the structure; these vehicles held long-dated assets funded by short-term debt.
  2. Currency mismatch between euro assets and US dollar insured retail depositsWhy not: The funding was wholesale, not insured retail deposits, and the key mismatch was maturity.
  3. Maturity mismatch: long-term assets funded by short-term liabilities - correct
  4. Interest rate floor risk because the debt had no maturity dateWhy not: The debt was short term with frequent maturities, not perpetual, so rollover risk was the issue.

Funding at overnight or a few months while holding multi-year assets means that a failure of lenders to roll over forces asset sales. Such rollover risk is the core of a run on wholesale funding.

A harder one

A dealer finances USD 100 million of securities in repo at a 5 percent haircut, so its equity is USD 5 million. The haircut rises to 20 percent while the securities' price is unchanged. Without raising equity, how much of the securities must the dealer sell?

  1. USD 15 millionWhy not: Takes the increase in the haircut (15 points) times 100 as the amount to sell, instead of recomputing capacity as equity / haircut.
  2. USD 75 million - correct
  3. USD 20 millionWhy not: Sells the new haircut percentage of the position, ignoring that equity limits assets to 25 million.
  4. USD 25 millionWhy not: Reports the position the dealer can still hold, 5 / 0.20, rather than the amount it must sell.

Maximum assets = equity / haircut = 5 / 0.20 = 25 million, so sale = 100 - 25 = 75 million. Rising haircuts reduce funding capacity quickly, forcing sales even if the securities' prices have not yet changed.

The hardest tier

A dealer has USD 98 million of securities financed with USD 95 million of repo, after a 2 percent fall in prices from an initial position of USD 100 million at a 5 percent haircut. Lenders now raise the haircut to 10 percent. The dealer sells securities at market value and uses all the proceeds to repay lenders. Ignoring any further price impact, the amount it must sell to meet the new haircut is closest to:

  1. USD 68 million - correct
  2. USD 9.8 millionWhy not: Applies the 10 percent haircut to the whole USD 98 million, as though that fraction of the securities had to be sold.
  3. USD 6.8 millionWhy not: Repays only the shortfall against the new limit (95 - 88.2) as if the collateral were unchanged; each dollar sold also removes a dollar of collateral.
  4. USD 88.2 millionWhy not: Reports the maximum debt that can now be supported (90% of 98), not an amount to sell.

Selling x of securities repays x of the repo and removes x of collateral, so the dealer needs 95 - x <= 0.90 x (98 - x). That gives 6.8 <= 0.10 x, so x >= USD 68 million. USD 6.8 million would only be enough if the collateral stayed unchanged, but with a 10 percent haircut each dollar sold releases just ten cents of extra capacity. A small price fall followed by a higher haircut can force sales of this size, which depress prices further: a loss and margin spiral.

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