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

27 Pages Posted: 14 Dec 2016

See all articles by Robert Barsky

Robert Barsky

Research Department, Federal Reserve Bank of Chicago; University of Michigan at Ann Arbor - Department of Economics; National Bureau of Economic Research (NBER)

Theodore Bogusz

Federal Reserve Bank of Chicago

Matthew Easton

Federal Reserve Bank of Chicago

Date Written: 2016-11-29

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 cycle, margins, financial crises, repo, risk, collateral, belief disagreements

JEL Classification: D53, E44, G00, G01

Suggested Citation

Barsky, Robert B. and Bogusz, Theodore and Easton, Matthew, Interest Rates or Haircuts? Prices versus Quantities in the Market for Collateralized Risky Loans (2016-11-29). Available at SSRN: https://ssrn.com/abstract=2885201

Robert B. Barsky (Contact Author)

Research Department, Federal Reserve Bank of Chicago ( email )

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University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
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734-764-9476 (Phone)
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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Theodore Bogusz

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

Matthew Easton

Federal Reserve Bank of Chicago

230 South LaSalle Street
Chicago, IL 60604
United States

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