Gallery

How do you give a bank a haircut?

How does a run on the repurchase market work?

The answer is: Haircuts.

In a repo loan, the borrower must secure the loan with collateral. How much collateral? That’s set by the lender.

Let’s say the lender wants $100 million in securities to collateralize a loan for $90 million. Then the haircut is 10 percent. During the financial crisis of 2007 and 2008, lenders demanded more collateral, increasing the haircut. The effect was like depositors demanding their money back from a bank. Both are runs on the bank.

“Haircuts,” the latest paper from Yale economists Andrew Metrick and Gary Gorton explaining their understanding of the crisis, defines haircut as “the percentage by which an asset’s market value is reduced for the purpose of calculating the amount of overcollateralization of the repo agreement.”

From the May 12, 2010, paper:

Increases in repo haircut are withdrawals from securitized banks, a bank run. When everyone does this and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. … Like the panics of the 19th century, the system is insolvent.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s