#09-32
Rollover Risk and Market Freeze
Viral Acharya, Douglas Gale and Tanju Yorulmazer, August 2009
For an earlier version of this paper, please see #09-01
Abstract:The crisis of 2007-09 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 finitely-lived assets with little credit risk. The borrowing in this model
takes the form of a repurchase agreement (“repo") or 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 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 the information state of the economy. At each date, in
general there is either “good news” (the information state improves), “bad news” (the information
state gets worse), or “no news” (the information state remains the same). When rollover risk is
high, because debt must be rolled over frequently, we show that the debt capacity is lower than the
fundamental value of the asset and in extreme cases may be close to zero. This is true even if the
fundamental value of the assets is high in all states. Interpreted differently, the model explains why
discounts on ABS collateral in overnight repo borrowing (the so-called “haircuts”) rose dramatically
during the crisis.
Keywords: financial crisis, credit risk, liquidation cost, haircut, repo, secured borrowing,
asset-backed commercial paper.
JEL classifications: G12, G21, G24, G32, G33, D8.
