Fire Sales in Frozen Markets

Ehsan Ebrahimy

No 2019/092, IMF Working Papers from International Monetary Fund

Abstract: It is challenging to explain the collapse in the price of subprime mortgage-backed securities (MBS) during the Financial Crisis of 2008, using the existing models of fire-sale. I present a model to demonstrate that fire-sales may happen even when there is a relatively sizable pool of natural buyers and in the absence of asymmetric information, due to a coordination failure among buyers: buyers’ waiting to trade at a lower price tomorrow, can lead to a collapse in the price and trade volume today. In particular, I show that when trade is decentralized and participation is endogenous, a medium level of asset demand and liquidity needs that are ex-pected to increase over time create complementarity among buyers’ decisions to wait. This complementarity makes competitive markets prone to coordination failures and fire-sales accompanied by a collapse in the trade volume. Fire-sales may also be inefficient. I also discuss various policy options to eliminate the risk of fire-sales in such a setup.

Keywords: WP; equilibrium price; asset market; asset price; asset Markets1; inefficient fire-sale; price impact; fire-sale equilibrium; decentralized asset Markets1; Asset liquidity; Asset prices; Liquidity; Securities markets (search for similar items in EconPapers)
Pages: 39
Date: 2019-05-06
New Economics Papers: this item is included in nep-dge
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