Interest Rates or Haircuts? Prices Versus Quantities in the Market for Collateralized Risky Loans

Robert Barsky, Theodore Bogusz and Matthew Easton

No WP-2016-19, Working Paper Series from Federal Reserve Bank of Chicago

Abstract: Markets for risky loans clear on two dimensions - an interest rate (or equivalently a spread above the riskless rate) and a specification of the amount of collateral per dollar of lending. The latter is summarized by the margin or \"haircut\" associated with the loan. Some key models of endogenous collateral constraints imply that the primary equilibrating force will be in the form of haircuts rather than movements in interest rate spreads. Indeed, an important benchmark model, derived in a two-state world, implies that haircuts will adjust to render all lending riskless, and that a loss of risk capital on the part of borrowers has profound effects on asset prices. Quantitative analysis of a model of collateral equilibrium with a continuum of states turns these results on their heads. The bulk of the response to lenders' perception of increased default risk is in the form of higher default premia. Further, with high initial leverage, reductions in risk capital decrease equilibrium margins almost proportionately, while asset prices barely move. To the extent that one believes that it is a stylized fact that haircuts move more than spreads - as seen, for example, in bilateral repo data from 2007-2008 - this reversal is disturbing.

Keywords: leverage cycles; margins; financial crises; repo; risk; collateral; belief disagreements (search for similar items in EconPapers)
JEL-codes: D53 E44 G00 G01 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2016-11-29
New Economics Papers: this item is included in nep-ban, nep-fmk and nep-mac
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Citations: View citations in EconPapers (1)

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