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

Author

Listed:
  • Barsky, Robert

    () (Federal Reserve Bank of Chicago)

  • Bogusz, Theodore

    (University of Michigan)

  • Easton, Matthew

    (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.

Suggested Citation

  • Barsky, Robert & Bogusz, Theodore & Easton, Matthew, 2016. "Interest Rates or Haircuts? Prices Versus Quantities in the Market for Collateralized Risky Loans," Working Paper Series WP-2016-19, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhwp:wp-2016-19
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    References listed on IDEAS

    as
    1. Ana Fostel & John Geanakoplos, 2012. "Leverage and Default in Binomial Economies: A Complete Characterization," Cowles Foundation Discussion Papers 1877RRR, Cowles Foundation for Research in Economics, Yale University, revised Mar 2015.
    2. Ana Fostel & John Geanakoplos, 2014. "Endogenous Collateral Constraints and the Leverage Cycle," Annual Review of Economics, Annual Reviews, vol. 6(1), pages 771-799, August.
    3. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
    4. Ana Fostel & John Geanakoplos, 2015. "Leverage and Default in Binomial Economies: A Complete Characterization," Econometrica, Econometric Society, vol. 83, pages 2191-2229, November.
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    Cited by:

    1. Breach , Tomas & King, Thomas B., 2018. "Securities Financing and Asset Markets: New Evidence," Working Paper Series WP-2018-22, Federal Reserve Bank of Chicago.

    More about this item

    Keywords

    leverage cycle; margins; financial crises; repo; risk; collateral; belief disagreements;

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G00 - Financial Economics - - General - - - General
    • G01 - Financial Economics - - General - - - Financial Crises

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