The Information Content of a Haircut

JM
March 27, 2010
 
Sometimes insights from really grim times show how the most loved assets can unravel and
how the crappiest suddenly become the finest. Data from the dark days of the credit crunch
indicate just what assets held the financial architecture together, and the crap that got
flushed.

Take-Aways
• The extent of haircuts is a good measure of the extent of systemic financial collapse.
• Primary counterparties and hedge funds took only minuscule haircuts on G-7
sovereign debt throughout the credit crisis.
• Post-crash, structured credit wasn’t accepted as collateral. This implies pre-crash
valuations were way off.
• Collateral haircut rates were different for primary dealers and hedge funds.

The data are aggregated survey results from the BIS Committee on the Financial System,
with some accompanying open questions. Only point estimates are available; there is no
indication of the “bid-ask” dispersion of haircuts. Respondents represent big dicks and
hedge funds. The survey instrument is at the end. More info on the survey and different
policy recommendations to make margining practices “stable through the cycle” can be
found at http://www.bis.org/publ/cgfs36.pdf?noframes=1. Stable through the cycle is
shorthand for a back-door way to control leverage ratios. Seems the idea could kill the repo
market if a severe enough crisis hits and MTM says something different than what
policymaker dictates. Leverage becomes a control lever. Is this really a great idea?

Results
The survey tells you something about real credit risk and what asset classes take the divine
hammer at the ground state. It also tells you something about different perceived
counterparty risks in the transactions.
Open Question

The results show clear segmentation of haircut rates between primary dealers and hedge
funds. Is this the result of Fed TSLF program for primary dealers?

It doesn’t seem like TSLF is the answer. Although there was some serious cash involved in
this program (see below), schedule 2 collateral includes only collateral eligible for tri-party
repurchase agreements arranged by the Open Market Trading Desk (stated as investment
grade only), AAA/Aaa-rated Private-Label Residential MBS, AAA/Aaa-rated Commercial MBS,
Agency CMOs, and other AAA/Aaa-rated ABS securities. So TSLF doesn’t explain the
difference in HY haircuts.

Source: SIFMA, Federal Reserve

Counterparty profile and reputation probably has more to do with it.

Asset Class Valuation Under Stress

The only collateral haircut that didn’t increase from June 2007 to June 2009 was G7
government debt. The haircut stayed constant for both primary dealers and unrated
counterparties (the vast majority of these are hedge funds) through the crunch. Never
forget that governments can and will raise taxes on the most credit-worthy as needed.
Doesn’t really matter who pays as long as it’s coughed up or it can be borrowed.

Astronomers postulate that a black hole is at the center of the Milky Way, and its
gravitational field is what holds everything together. If the financial system is anything like
a galaxy, then Treasuries are a stinky part of the black hole.
Open Question

Are haircuts more influenced by MTM collateral performance or credit ratings?

Looks like collateral performance. I don’t think that ratings agencies kept up with
increasing haircut demands, although I could be wrong. Just looking at the extreme end of
term security financing indicates that IG haircuts increased by 10% in less than two years,
and HY haircuts increased by 20%.

There’s even more anecdotal support here. The survey says something about pre- and
post-crash valuations and rating agency models. AAA structured securitizations were not
accepted as collateral by 2009. Clear ratings meant nothing for the asset class value in this
case.

Prime counterparty haircuts for AAA-AA IG increased from 1% to 8%. The haircut
approximately doubled for other cases. Note the 40% haircut for HY in June 2009
compared to 20% in 2007.

Haircuts Control Leverage

There were some pretty draconian haircut rates that emerged out of the crisis. The idea of
smoothing these haircuts rates over a… liquidity cycle… is novel. It’s like wagging the dog
by its tail. Haircuts rise for a reason: bursts of clarity about fundamentals, panic,
whatever. That haircuts rise is no more or less irrational than any other market action that
goes on.

If you think through the effect of haircuts on leverage, you can see the mechanics of
markets working here like everywhere. Think of the mortgage market. If a bank requires
more down-payment to release a home loan, the leverage is reduced on the loan. The
down-payment in the term financing described are the collateral assets. The haircut
controls the leverage of the financing.

Even though the monthly payment is lower, there are fewer people that can afford a home
because they don’t want to or can’t lock up so much capital. The market operates how it
did before when the price of the home goes down, or when more leverage is embedded in
the transaction. Same thing going on here. The market above is at the core of economic
motion. When it glitches, everything feels it. This doesn’t make risk reduction any easier.

The Instrument