Working Paper: NBER ID: w15674
Authors: Viral V. Acharya; Douglas Gale; Tanju Yorulmazer
Abstract: The crisis of 2007-09 has been characterized by a sudden freeze in the market for short-term, secured borrowing. We present a model that can explain a sudden collapse in the amount that can be borrowed against finitely-lived assets with little credit risk. The borrowing in this model takes the form of a repurchase agreement ("repo") or asset-backed commercial paper that has to be rolled over several times before the underlying assets mature and their true value is revealed. In the event of default, the creditors can seize the collateral. We assume that there is a small cost of liquidating the assets. The debt capacity of the assets (the maximum amount that can be borrowed using the assets as collateral) depends on the information state of the economy. At each date, in general there is either "good news" (the information state improves), "bad news" (the information state gets worse), or "no news" (the information state remains the same). When rollover risk is high, because debt must be rolled over frequently, we show that the debt capacity is lower than the fundamental value of the asset and in extreme cases may be close to zero. This is true even if the fundamental value of the assets is high in all states. Thus, a small change in information, as measured by a change in the fundamental value, can lead to a "market freeze." Interpreted differently, the model explains why discounts in overnight repo borrowing, the so-called "haircuts," rose dramatically during the crisis for asset-backed securities with low credit risk once bad news about the underlying cash flows arrived.
Keywords: Rollover risk; Market freezes; Debt capacity; Financial crisis
JEL Codes: D80; G12; G21; G24; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high rollover risk (G11) | debt capacity of assets (G32) |
| debt capacity of assets (G32) | market freeze (D49) |
| information states (H70) | debt capacity of assets (G32) |