An arcane topic that we've visited a few times.*
From the Federal Reserve Bank of New York's Liberty Street blog:
Short-Term Debt, Rollover Risk, and Financial Crises
One of the many striking features of the recent financial crisis was the sudden “freeze” in the market for the rollover of short-term debt. In this post, based on my paper “Rollover Risk and Market Freezes,” I explain how firms may be unable to borrow overnight against high-quality assets even in the absence of the usual frictions (asymmetric information, adverse selection, or moral hazard) that can cause credit rationing.
Two FreezesHT: FT Alphaville
The first such market freeze occurred in the summer of 2007. On July 31, two Bear Stearns hedge funds based in the Cayman Islands and invested in subprime assets failed. The following week, more news of problems with subprime assets hit the markets. On August 9, BNP Paribas halted withdrawals from three investment funds and suspended calculation of their net asset values because it could not “fairly” value the funds’ holdings. This announcement appeared to cause investors in asset-backed commercial paper (ABCP), primarily money market funds, to shy away from further financing of ABCP structures. Since many ABCP vehicles had recourse to sponsoring banks that provided them with liquidity and credit enhancements, if ABCP debt could not be rolled over, the sponsoring banks would have to take assets back onto their balance sheets. In that case, given the assets’ illiquidity, the ability of the banks to raise additional financing would be limited too. Money market funds thus faced the risk that the assets underlying ABCP would be liquidated at a loss. This liquidation and rollover risk produced a freeze in the ABCP market, raised concerns about counterparty risk among banks, and caused the Libor to rise. Providing evidence of such a freeze, Gorton and Metrick (2010) show that during 2007-08, the repo haircuts on a variety of assets rose on average from zero in early 2007 to nearly 50 percent in late 2008. Interestingly, while some of the collateralized debt obligations had a 100 percent haircut and thus no secured borrowing capacity at all during the crisis, equities—which are in principle much riskier assets—had only around a 20 percent haircut.
The failure of Bear Stearns in mid-March 2008 offers a second example of a market freeze. (A March 20 Securities and Exchange Commission press release provides an interesting discussion of the account.) As an intrinsic part of its business, Bear Stearns relied on day-to-day, short-term financing through secured borrowing. Beginning late on Monday, March 10, rumors about liquidity problems at Bear Stearns eroded investor confidence in the firm. Even though Bear Stearns continued to have high-quality collateral, counterparties became less willing to enter into collateralized funding arrangements with the firm. This resulted in a crisis of confidence and led to a sharp and continuous fall in Bear Stearns’ liquidity, which caused the near-failure of the firm. Furthermore, even at the time of the firm’s sale, the capital ratio of Bear Stearns was well in excess of the 10 percent level used by the Federal Reserve as its standard for well-capitalized banks. As Chairman Bernanke observed, “Until recently, short-term repos had always been regarded as virtually risk-free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-term unsecured obligations. In March, rapidly unfolding events demonstrated that even repo markets could be severely disrupted when investors believe they might need to sell the underlying collateral in illiquid markets.”
Why the Freezes?...MORE
*Back in August 2007, a week after the "Quant-quake", we posted "Liquidity in Business and Markets":
Liquidity is expensive but illiquidity is much more so,
because it destroys the very existence of a firm"
I don't remember if it was Johannes or Ernst, it was a long time ago that I read Manchester, quoting one of the Schroeder boys on the insolvency of Krupp. That line has stuck with me. Here's the book....
In July 2011 it was "The Black Swan Isn't the Debt Ceiling, It is Holders of U.S. Treasuries Asking for Cash Rather Than Rolling the Paper"
Last Friday: "Too Funny: "GE Capital CEO "sympathetic" to Wall Street protests'":
...Three years ago this month, in the Fall of 2008 no one on earth would touch GE Credit's commercial paper and the entire company was within days of becoming insolvent.
The company had been padding reported earnings by borrowing short and lending long, at one point having over $100 Billion in CP outstanding.
The borrow short/lend long scam is a great way to increase your bonus but in finance it's nothing short of playing Russian roulette....