Correct ‘Haircuts’

‘Haircut’ is a term that has a precise meaning in finance. But many journalists and commentators use the term incorrectly, which is unfortunate because ‘haircuts’ have played a major role in the GFC. Knowing what haircuts really are is crucial to understanding the liquidity crises of the GFC.

He re is a test: Which of the following two statements makes correct useage of the term ‘haircut’?

  1. When the Cypriot banks were bailed out, in March 2013, large depositors were forced to take a 50 percent ‘haircut’ on their deposits of over 100,000 euros; or
  2. European banks can only borrow 75 euros of cash against each 100 euros of BBB rated bonds that they provide as security because the ECB imposes a 25 percent haircut on those bonds.

Answer: Statement 2 correctly describes a haircut. A haircut is applied to collateral that is used to secure very short term borrowing (usually overnight borrowing). If you have to post $100 of collateral to borrow $90 of cash then your collateral has received a 10 percent haircut.

St atement 1 actually describes a ‘write-down’. When a set of lenders are forced to accept a reduction in the amount of a bond or loan that will be repaid, that is not a ‘haircut’, it is a ‘write-down’ of the principal. For example, in February 2012 the non-government owners of 206 billion euros of Greek Government bonds were forced to accept a 53.5% write down of the principal of those bonds (they were also forced to accept longer maturities and lower interest rates).

Wr ite-downs apply to long or medium term bonds and loans - therefore, write-downs are part of the capital markets. Haircuts apply to the collateral used to secure very short term loans - therefore, haircuts are part of the money markets.

Haircuts on borrowing to buy bonds

Haircuts were a crucial part of the liquidity crisis that hit shadow banks in 2007/8. To understand how haircuts affected shadow banks, lets start with an example of a hedge fund that invests in US treasury bonds. Imagine that the hedge fund wished to buy $100 million of US treasury bonds but wanted to use as little as possible of its own capital to finance the ownership of the bonds. The hedge fund can do the following:

  1. Buy the bonds from a bond dealer for $100 million and promise to pay for the bonds tomorrow.
  2. Go to the repo market and pledge all $100 million of the purchased bonds as collateral to obtain an overnight loan for $98 million - a hairccut of 2%.
  3. Pay the bond dealer the $100 million using the $98 million loan plus $2 million of the hedge fund’s own capital.
  4. Then roll over the 1 day loan in the repo market, day after day.
  5. When the hedge fund finally sells the bonds, it demands immediate payment for the bonds (so it has the cash) and then lets the overnight repo loan lapse: handing the bonds to new buyer; the $98 million in cash to the repo market lender; and pocketing its $2 million in capital plus the capital gain (or loss) on the bond.

Haircuts define leverage

The size of the haircut determines the leverage that the hedge fund can achieve. The hedge fund can borrow 98% and use only 2% of its own capital to finance the position because of the 2% haircut. The 2% haircut allows a leverge of 49 to 1. Imagine that, instead of treasury bonds, the hedge fund was borrowing to fund a holding of AA rated corporate notes. Then the haircut might be 5% and the hedge fund could only borrow $95 million against the bonds and ‘only’ achieve a leverage of 19 to 1.

Shadow banks

The hedge fund in our example is acting as a ‘shadow’ bank. Real (commercial) banks borrow short term (deposits) to fund long term assets (loans). That business is profitable because short term interest rates are usually lower than long term interest rates and the bank earns the difference. The hedge fund is behaving just like a real bank in borrowing short-term (overnight in the repo market) to fund the ownership of long term assets (government bonds).

Borrowing short term and lending long term is profitable but highly risky in liquidity terms. If depositors lose confidence in the value of a real bank’s assets (the loans), then there will be a ‘run’ on the bank as depositors demand their money back at short notice. However, the Federal Government protects banks against runs. Firstly, by guaranteeing deposits (so money actually flows into banks in financial crises), and secondly, by allowing banks to borrow directly from the central bank (through the discount window).

If the lenders in the repo market lose confidence in the assets of a shadow bank (the bonds) then the repo market will widen the haircuts on those loans. This is not exactly a ‘run’ on the shadow bank, but it does reduce its capacity to finance assets - it is a loss of funding. Moreover, shadow banks are not protected by the Federal Government - which is why they pose a danger to the financial system.

Shadow banks in the sub-prime crisis

This widening of haircuts in the repo market is exactly what happened in the sub-prime crisis. Many hedge funds, investment banks, special investment vehicles, and other shadow banks were using the repo market to finance the ownership of different types of risky bonds; including bonds issued by securitisers of sub-prime mortgages. When the repo market lost confidence in the value of those sub-prime securitisation bonds the haircuts on them were quickly increased from 3% to 5%, and then to 10%, and ultimately to 50% in many cases.

Suddenly the shadow banks couldn’t raise enough cash to fund their holdings of sub-prime mortgage bonds. So they were forced to sell bonds into the market to get cash. All kinds of risky bonds were dumped into the bond markets - corporate bonds, quality securitisation bonds, emerging market sovereign bonds, as well as the low quality sub-prime bonds. The credit spread (yield over equivalent treasury bonds) on AA rated corporate bonds in the US jumped from 65 basis points (0.65%) to 350 basis points in just a few weeks in the second half of 2007.

2007 firesale in the bond markets

The haircuts in the repo market were the mechanism by which the problems in the sub-prime securitisation bonds spread to all other risky bonds.

  1. The market lost faith in sub-prime securitisation bonds, so the haircuts on sub-prime bonds widened quickly.
  2. Shadow banks could no longer fully fund those bonds in the repo market, but could not easily sell the bonds either because dealers were not making a market in those bonds.
  3. So, shadow banks dumped all kinds of other risky bonds causing their prices to collapse and yields to rise. This caused the haircuts on all risky bonds to widen (reducing their value) and forced shadow banks to sell more bonds, making the crisis worse.

The problems in the sub-prime mortgage bonds caused a firesale of all types of risky bonds, even those bonds that had nothing to do with sub-prime mortgages. This episode is a crucial part of the GFC, but it can only be understood with a correct understanding of what ‘haircuts’ are.

Greek banks in 2015

Note that the ECB (European Central Bank) is now imposing larger haircuts on Greek government bonds. To meet the outflow of deposits, Greek banks are taking their Greek Government bonds to the ECB and pledging them for overnight loans of cash. The increased haircuts are reducing the amount of liquidity those banks can access.