NY Fed Liberty Street Economics post on repo haircuts and fire sales: we think they may have missed some stuff

A Fed NY Liberty Street Economics blog post “Are Higher Haircuts Better? A Paradox” was published on Aug. 19th. The authors, Brian Begalle, Adam Copeland, Antoine Martin, Jamie McAndrews, and Susan McLaughlin, look at how haircuts might impact bank behavior. It is interesting, but does not entirely capture how things work.

We know that a number of SFM posts have looked at recent Liberty Street Economics blog posts. But the material is full of good stuff – and how could we pass up an article on haircuts and fire sales?

The authors are thinking in the context of fire sales of repo collateral. They note that higher haircuts cut both ways. In a pre-default world, it is suggested that higher haircuts reduce the propensity for a fire sale since there is more credit cushion (and this would mean liquidation could take its time – a good thing). But post-default, higher haircuts mean that a repo desk’s break even is lower and encourages a sell first, ask questions later mentality, AKA fire sales.

From the post,

“…There are a number of reasons to like high haircuts: 1) they limit the leverage and, thus, the fragility of borrowers, 2) they provide better protection for lenders, making them less likely to run, and 3) if already high in good times, they will likely need to increase less during times of stress, which could dampen the type of dramatic increase that Gorton and Metrick identified and help avoid the “scramble” for alternative sources of funding during a period of already tight credit conditions…”

and

“…If high haircuts can help mitigate the risk of pre-default fire sale, they can have a perverse effect and increase the risk of post-default fire sales. The latter type can occur because repos benefit from special treatment in the case of bankruptcy. Unlike many types of transactions that are subject to the automatic stay of bankruptcy, repos are exempt. (In the United States, a defaulting broker dealer is resolved under the Securities Investor Protection Act, which imposes a stay on liquidation of securities collateral. This stay is expected to be lifted in a short time period.) So, once a repo borrower has gone into default, the cash lenders can sell the repo securities to repay their loans…”

The post-default scenario sounds absolutely correct. No repo desk (or cash lender) is paid to hold onto paper once their client has defaulted (perhaps with the exception of when they might face a big loss, but not one which forces them into bankruptcy).  Of course some assets are easier to sell than others anyway. Govies can be liquidated pretty quickly without much impact on market prices. Toxic corporate or mortgage paper – that’s a different story. That is why haircuts vary substantially by asset class. Or should.

But pre-default? Something doesn’t sound right. Who exactly is selling paper pre-default and why is their incentive any different from the post-default scenario? If the paper consists of, for example, inventory positions being financed by the repo desk in tri-party, the bank is giving the haircut away. Dealer positions being taken out of tri-party and sold for liquidity don’t have any financing cushion from a haircut – actually the opposite. Selling because a fear that financing is going to be cut off is not driven by haircut. High haircut or low haircut — it’s the last thing anyone is thinking about. Even if the repo desk took the haircut (they gave to the tri-party cash provider) from the dealer desk into consideration, it is a firm wide zero sum game.

If it is about tri-party cash lenders selling paper pre-default – well, that doesn’t make any sense. They can only sell collateral after a default has happened. And even then, for a host of reasons, the incentives to sell as fast as possible will be difficult to resist. Tri-party cash lenders can close out their short-dated trades pre-default, but that doesn’t mean they are selling paper unless the repo unwind defaults. 

If the focus is on financed client positions (held by repo desks) being sold pre-default, it still seems odd. This is not like a short sale on a house where the bank accepts less money before it goes to foreclosure (e.g. default). The client positions will get sold by the client and the repo desk paid off in full. If not, then there is a default and the bank will do what they have to do. If the client is closing out their financing and selling the positions – perhaps in a fire sale – the more skin the clients have in the game (via higher haircuts) the better off the dealer should feel if shortfalls lead to default. That is consistent with higher haircuts being better for dealing with post-default liquidations.

All of this is about preventing fire sales. Can you draw a line between haircuts and fire sales? It seems, at least on the pre-default side, to be a tough argument to make. The more relevant metric might be the mark to market of the portfolio of assets (when the time comes to sell) relative to the financial condition of the seller. Whether pre- or post-default, if there is no loss to be taken by selling, they will get sold ASAP. If there is a big loss, cash lenders will think twice about selling unless they are on the edge of bankruptcy. It is what is in the middle that creates all the uncertainty.

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