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Are Higher Haircuts Better? A Paradox

Author

Listed:
  • Brian Begalle
  • Adam Copeland
  • Antoine Martin
  • James J. McAndrews
  • Susan McLaughlin

Abstract

Repurchase agreement (repo) markets played an important role in the 2007-09 financial crisis in the United States, and much discussion since then has focused on the role of repo haircuts. A repo is essentially a loan collateralized by securities. Typically, the value of the securities exceeds the value of the loan and the amount of overcollateralization corresponds to the haircut. In a 2010 paper, Yale?s Gary Gorton and Andy Metrick identified a dramatic increase in haircuts in the bilateral segment of the repo market, which they interpreted as a run on repo. Separately, an industry task force aimed at reforming a different segment of the market, the tri-party repo market, indicated that haircuts may have been too low during the crisis, given the volatility of many of the underlying assets? values. Maintaining higher haircuts throughout the business cycle could solve both problems: the excessively rapid increase in haircuts in the bilateral segment of the market and the low level of haircuts in the tri-party segment. But are permanent higher haircuts always better? In this post, we dig a little deeper and find that they can have paradoxical effects.

Suggested Citation

  • Brian Begalle & Adam Copeland & Antoine Martin & James J. McAndrews & Susan McLaughlin, 2013. "Are Higher Haircuts Better? A Paradox," Liberty Street Economics 20130819, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednls:86889
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    More about this item

    Keywords

    Repo; haircuts;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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