The Sub prime crisis and Liquidity Risk

The sub prime crisis was as much about liquidity as about insolvency. Many banks suffered during the sub prime crisis because of a capital structure that relied too heavily on debt.

Markus Brunnermeir[1] points out that a loss spiral arises for leveraged investors because a decline in the value of assets erodes the investors’ net worth much faster than their gross worth. The amount that they can borrow falls sharply. For example, consider an investor with a leverage ratio of 1:10, who buys $100 million worth of assets on 10 percent margin. This investor finances only $10 million with his own capital and borrows $90 million. Say the value of the acquired asset declines temporarily to $95 million. The investor, who started out with $10 million in capital, now has lost $5 million. So there is only $5 million of capital remaining. To prevent the leverage ratio from going up, this investor must reduce the overall position to $50 million. In other words, $45 million of assets must be sold. And this sale will happen exactly when the price is low. These sales will depress the price further, inducing more selling and so on. This loss spiral will get aggravated if some other potential buyers with expertise may face similar constraints at the same time. The spiral will also get amplified if other potential buyers find it more profitable to wait out the loss spiral before reentering the market. Indeed, traders might even engage in “predatory trading,” deliberately forcing others to liquidate their positions at fire-sale prices.

The margin/haircut spiral reinforces the loss spiral. As margins or haircuts rise, the investor has to sell assets to reduce the leverage ratio. Margins and haircuts spike in times of large price drops, leading to a general tightening of lending. A vicious cycle emerges, where higher margins and haircuts force de-leveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria.

An increase in counterparty credit risk can create additional funding needs and potential systemic risk. Brunnermeir has illustrated this by an example related to the Bear Stearns crisis in March 2008. Imagine a hedge fund that had an interest rate swap agreement with Goldman Sachs. Say the hedge fund offset its obligation through another swap with Bear Stearns. In the absence of counterparty credit risk, the two swap agreements would together be viewed essentially as a single one between Goldman and Bear Stearns. However, it would be unwise for Goldman to renew the contract if it feared that Bear might default on its commitment. Goldman was asked to increase its direct exposure to Bear after the trading hours on March 11, 2008 when Bear was approaching bankruptcy. Goldman did renew the contract in the morning of March 12. But the delay in response was mistakenly interpreted as a hesitation on Goldman’s behalf and fear that Bear Stearns might be in trouble. This misinterpretation was leaked to the media and seems to have contributed to the run on Bear Stearns.

Indeed, an increase in perceived counterparty credit risk can be self-fulfilling and create additional funding needs. Suppose that Bear Stearns had an offsetting swap agreement with a private equity fund, which in turn offset its exposure with Goldman Sachs. All parties, taken together, are fully hedged. However, each party is aware only of its own contractual agreements. So it may not know the full situation and therefore become concerned about counterparty credit risk. If the investment banks refuse to let the hedge fund and private equity fund net their offsetting positions, both funds have to either put up additional liquidity, or insure each other against counterparty credit risk by buying credit default swaps. This happened in the week after Lehman’s bankruptcy. All major investment banks were worried that their counterparties might default. So they bought credit default swap protection against each other. The already high prices on credit default swaps of the major investment banks almost doubled. The price of credit default swaps for AIG was hit the worst. It more than doubled within two trading days. Such problems are more easily overcome if there is a central clearinghouse which knows who owes what to whom. Indeed, many economists have argued strongly in favour of moving away from OTC to central clearing arrangements for most if not all derivatives.
[1] “Deciphering the liquidity and credit crunch 2007-2008” Journal of Economic Perspectives, Winter 2009, pp. 77-100.