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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27876
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| Title: | Rollover Risk and Market Freezes |
| Authors: | Acharya, Viral
Gale, Douglas
Yorulmazer, Tanju |
| Issue Date: | 6-Feb-2009 |
| Series/Report no.: | FIN-08-030 |
| Abstract: | The sub-prime crisis of 2007 and 2008 has been characterized by a sudden
freeze in the market for short-term, secured borrowing. We present a
model that can explain a sudden collapse in the amount that can be
borrowed against assets with little credit risk. The borrowing in this
model takes the form of asset-backed commercial paper that has to be
rolled over several times before the underlying assets mature and their
true value is revealed. In the event of default, the creditors (holders
of commercial paper) can seize the collateral. We assume that there is a
small cost of liquidating the assets. The debt capacity of the assets
(the maximum amount that can be borrowed using the assets as collateral)
depends on how information about the quality of the asset is revealed.
In one scenario, there is a constant probability that "bad
news" is revealed each period and, in the absence of bad news, the
value of the assets is high. We call this the "optimistic"
scenario because, in the absence of bad news, the expected value of the
assets is increasing over time. By contrast, in another scenario, there
is a constant probability that "good news" is revealed each
period and, in the absence of good news, the value of the assets is low.
We call this the "pessimistic" scenario because, in the
absence of good news, the expected value of the assets is decreasing
over time. In the optimistic scenario, the debt capacity of the assets
is equal to the fundamental value (the expected NPV), whereas in the
pessimistic scenario, the debt capacity is below the fundamental value
and is decreasing in the liquidation cost and frequency of rollovers. In
the limit, as the number of rollovers becomes unbounded, the debt
capacity goes to zero even for an arbitrarily small default risk. Our
model explains why markets for rollover debt, such as asset-backed
commercial paper, may experience sudden freezes. The model also provides
an explicit formula for the haircut in secured borrowing or repo transactions. |
| URI: | http://hdl.handle.net/2451/27876 |
| Appears in Collections: | Finance Working Papers
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