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Working Paper
Transparency and Collateral : Central versus Bilateral Clearing
Bilateral financial contracts typically require an assessment of counterparty risk. Central clearing of these financial contracts allows market participants to mutualize their counterparty risk, but this insurance may weaken incentives to acquire and to reveal information about such risk. When considering this trade-off, participants would choose central clearing if information acquisition is incentive compatible. If it is not, they may prefer bilateral clearing, when this choice prevents strategic default while economizing on costly collateral. In either case, participants independently ...
Working Paper
The (Unintended?) Consequences of the Largest Liquidity Injection Ever
The design of lender-of-last-resort interventions can exacerbate the bank-sovereign nexus. During sovereign crises, central bank provision of long-term liquidity incentivizes banks to purchase high yield eligible collateral securities matching the maturity of the central bank loans. Using unique security level data, we find that the European Central Bank's 3-year Long-Term Refinancing Operation caused Portuguese banks to purchase short-term domestic government bonds, equivalent to 10.6% of amounts outstanding, and pledge them to obtain central bank liquidity. The steepening of Eurozone ...
Working Paper
Emergency Collateral Upgrades
During the 2008-09 financial crisis, the Federal Reserve established two emergency facilities for broker-dealers. One provided collateralized loans. The other lent securities against a pledge of other securities, effectively providing collateral upgrades, an operation similar to activities traditionally undertaken by broker-dealers. We find that these facilities alleviated dealers' funding pressures when access to repos backed by illiquid collateral deteriorated. We also find that dealers used the facilities, especially the ability to upgrade collateral, to continue funding their own illiquid ...
Working Paper
Interest Rate Dynamics, Variable-Rate Loan Contracts, and the Business Cycle
The interest rate at which US firms borrow funds has two features: (i) it moves in a countercyclical fashion and (ii) it is an inverted leading indicator of real economic activity: low interest rates forecast booms in GDP, consumption, investment, and employment. We show that a Kiyotaki-Moore model accounts for both properties when business-cycle movements are driven, in a significant way, by animal spirit shocks to credit-financed investment demand. The credit-based nature of such self-fulfilling equilibria is shown to be essential: the dynamic correlation between current loanable funds rate ...
Report
Is It Too Late to Bail Out the Troubled Countries in the Eurozone?
In January 1995, U.S. President Bill Clinton organized a bailout for Mexico that imposed penalty interest rates and induced the Mexican government to reduce its debt, ending the debt crisis. Can the Troika (European Commission, European Central Bank, and International Monetary Fund) organize similar bailouts for the troubled countries in the Eurozone? Our analysis suggests that debt levels are so high that bailouts with penalty interest rates could induce the Eurozone governments to default rather than reduce their debt. A resumption of economic growth is one of the few ways that the Eurozone ...
Working Paper
Collateralized Debt Networks with Lender Default
The Lehman Brothers' 2008 bankruptcy spread losses to its counterparties even when Lehman was a lender of cash, because collateral for that lending was tied up in the bankruptcy process. I study the implications of such lender default using a general equilibrium network model featuring endogenous leverage, endogenous asset prices, and endogenous network formation. The multiplex graph model has two channels of contagion: a counterparty channel of contagion and a price channel of contagion through endogenous collateral price. Borrowers diversify their lenders because of the counterparty risk, ...
Working Paper
Safe Collateral, Arm's-Length Credit : Evidence from the Commercial Real Estate Mortgage Market
When collateral is safe, there are less opportunities for things to go wrong. We examine matching between collateral and creditors in the commercial real estate mortgage market by comparing loans in commercial mortgage backed securities (CMBS) conduits and bank portfolios. We model CMBS financing as lower cost but less informed, such that only safe collateral is funded by CMBS. This prediction is tested using the 2007-2009 shutdown of the CMBS market as a natural experiment. The loans funded by banks that would have been securitized are less likely to default or be renegotiated, indicating ...
Working Paper
Transparency and Collateral: The Design of CCPs' Loss Allocation Rules
This paper adopts a mechanism design approach to study optimal clearing arrangements for bilateral financial contracts in which an assessment of counterparty risk is crucial for efficiency. The economy is populated by two types of agents: a borrower and lender. The borrower is subject to limited commitment and holds private information about the severity of such lack of commitment. The lender can acquire information at a cost about the commitment of the borrower, which affects the assessment of counterparty risk. When truthful revelation by the borrower is not incentive compatible, the ...
Working Paper
Collateral Runs
This paper models an unexplored source of liquidity risk faced by large broker-dealers: collateral runs. By setting different contracting terms on repurchase agreements with cash borrowers and lenders, dealers can source funds for their own activities. Cash borrowers internalize the risk of losing their collateral in case their dealer defaults, prompting them to withdraw it. This incentive creates strategic complementarities for counterparties to withdraw their collateral, reducing a dealer's liquidity position and compromising her solvency. Collateral runs are markedly different than ...
Working Paper
The Scarcity Value of Treasury Collateral: Repo Market Effects of Security-Specific Supply and Demand Factors
In the repo market, forward agreements are security-specific (i.e., there are no deliverable substitutes), which makes it an ideal place to measure the value of fluctuations in a security's available supply. In this study, we quantify the scarcity value of Treasury collateral by estimating the impact of security-specific demand and supply factors on the repo rates of all the outstanding U.S. Treasury securities. Our results indicate the existence of an economically and statistically significant scarcity premium, especially for shorter-term securities. The estimated scarcity effect is quite ...