Rollover Risk and Market Freezes

Abstract

The sub-prime crisis of 2007 and 2008 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 assets with little credit risk. The borrowing in this model takes the form of 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 (holders of commercial paper) 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 how information about the quality of the asset is revealed. In one scenario, there is a constant probability that "bad news" is revealed each period and, in the absence of bad news, the value of the assets is high. We call this the "optimistic" scenario because, in the absence of bad news, the expected value of the assets is increasing over time. By contrast, in another scenario, there is a constant probability that "good news" is revealed each period and, in the absence of good news, the value of the assets is low. We call this the "pessimistic" scenario because, in the absence of good news, the expected value of the assets is decreasing over time. In the optimistic scenario, the debt capacity of the assets is equal to the fundamental value (the expected NPV), whereas in the pessimistic scenario, the debt capacity is below the fundamental value and is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions.J.E.L. Classification: G12, G21, G24, G32, G33, D8.

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“…When the repo is rolled over at time t = 1, the interest rate on the repo at rate r2 may be higher than the rate at the outset. This “rollover risk” (Acharya, Gale, & Yorulmazer, ) and the associated costs are intimately related to the availability of funding. Thus, funding liquidity and asset liquidity are important determinants of the difference between CDS prices and yield spreads.…”

How Do Market Prices and Cheap Talk Affect Coordination?

“…The distinction between illiquidity and insolvency is hard to draw because fundamentals are unobservable. For example, many argue that capital withdrawals from lenders contributed to the collapse of Bear Stearns, an investment bank that relied heavily on short term borrowing (Cox [], Morris and Shin [], Acharya, Gale, and Yorulmazer []). Many others believe that poor asset quality was the cause of its demise.…”

A Model of Monetary Policy and Risk Premia

“…Recently, rollover risk played a important role in the 2008 financial crisis (Acharya, Gale, and Yorulmazer ()). Since the crisis, financial institutions have responded in part by stocking greater quantities of liquid assets (Financial Stability Oversight Council ()), consistent with our model.…”