Rollover Risk and Market Freezes
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
Douglas M. Gale
New York University (NYU) - Department of Economics
Federal Reserve Bank of New York
February 17, 2010
NYU Working Paper No. FIN-08-030
We present a model that can explain a sudden drop in the amount of money that can be borrowed against an asset, even in the absence of asymmetric information or fears about the value of the collateral. Three features of the model are essential: (i) the debt has a much shorter tenor than the assets and needs to rolled over frequently; (ii) in the event of default by the borrower, the collateral is sold by the creditors and there is a (small) liquidation cost; (iii) a significant fraction of the potential buyers of the collateral also relies on short-term debt finance. Under these conditions, the debt capacity of the assets (the maximum amount that can be borrowed using the securities as collateral) can be much less than the fundamental value, and in fact, equal the minimum possible value of the asset. This is true even if the fundamental value of the assets is currently high. In particular, a small change in the fundamental value of the assets can be associated with a sudden collapse in the debt capacity. The crisis of 2007-09 was characterized by just such a sudden freeze in the market for short-term, asset-backed financing.
Number of Pages in PDF File: 60
Keywords: financial crisis, credit risk, liquidation cost, repo, secured borrowing, asset-backed commercial paper.
JEL Classification: G12, G21, G24, G32, G33, D
Date posted: March 9, 2009 ; Last revised: August 9, 2010