Rollover Risk and Market Freezes

TLDR: In this article, the authors show that a small change in the asset's fundamental value can be associated with a catastrophic drop in the debt capacity, the kind of market freeze observed during the crisis of 2007 to 2008.

Abstract: The debt capacity of an asset is the maximum amount that can be borrowed using the asset as collateral. We model a sudden collapse in the debt capacity of good collateral. We assume short-term debt that must be frequently rolled over, a small transaction cost of selling collateral in the event of default, and a small probability of meeting a buy-to-hold investor. We then show that a small change in the asset's fundamental value can be associated with a catastrophic drop in the debt capacity, the kind of market freeze observed during the crisis of 2007 to 2008. One of the many striking features of the crisis of 2007 to 2008 was the sudden freeze in the market for the rollover of short-term debt. From an in? stitutional perspective, the inability to borrow overnight against high quality but long-term assets was a market failure that effectively led to the demise of a substantial part of investment banking in the United States. More broadly, it led to the collapse, in the United States, the United Kingdom, and other countries, of banks and other financial institutions that had relied on signifi? cant maturity mismatch between assets and liabilities, and, in particular, on the rollover of short-term wholesale debt in the asset-backed commercial paper (ABCP) and overnight sale and repurchase (repo) markets. In this paper, we are interested in developing a model of a sudden collapse in the ability to borrow short-term against long-lived assets in the absence of obvious problems of asymmetric information or fears about the value of col? lateral. We refer to this phenomenon as a "market freeze." More precisely, a market freeze occurs when the debt capacity, the maximum amount of collat eralized borrowing that can be supported by an asset, is a small fraction of the fundamental value, the economic value measured by the net present value (NPV) of the stream of future returns. An extreme form of a market freeze occurs when the fundamental value is close to the maximum possible value of the asset whereas the debt capacity is close to the minimum possible value of the asset.

Figures

Figure 7: Repo haircuts over states

Figure 4: Fundamental value (V) as a function of time

Figure 6: Fundamental value (V) and debt capacity(B) over states

Figure 2: Fundamental value (V) and debt capacity (B) in high (H) and low (L) states as a function of time (t)

Figure 3: Fundamental value (V) and debt capacity (B) in low (L) state as a function of time (t) for rollover frequencies (N)

Figure 5b: Debt capacity (B) as a function of time (N = 10,000)