When Lehman Brothers collapsed last fall, its creditors quickly moved to sell their portion of the institution’s collateral assets. This large-scale fire sale drove down the assets’ price, further fueling instability in financial markets.
It’s common for creditors to sell their collateral assets on the heels of a default, but when multiple creditors rush to sell, a classic coordination problem arises. “A creditor knows that as others sell, they will drive down the collateral assets’ price and if the creditor doesn’t join the race, it will suffer significant financial losses,” says Professor Martin Oehmke, whose research interests include asset pricing and financial intermediation.
The dynamic is more acute now because in the past few years borrowers have increasingly used illiquid assets as collateral in secured lending markets, such as the repurchase agreement market, which at roughly 12 trillion dollars is one of the central hubs in the financial system. “Illiquid collateral can be difficult to convert into liquid assets, such as cash, and illiquid assets usually sustain noticeable price drops when sold.” Oehmke explains.
Slowly liquidating assets over time is the best way for creditors to minimize large drops in price, thereby maximizing proceeds. But a creditor may not be able to sell the collateral assets slowly if they cannot afford to hold the risky collateral assets on their balance sheet for an extended period of time. Further, when multiple creditors are in play, the competitive pressure builds and can make it impossible — even for creditors that have strong balance sheets — to afford the luxury of selling slowly. Because other sellers will drive down the collateral asset’s price, the best thing to do is to also sell quickly, resulting in a rush to sell. Prices might recover over time, but the initial drop can negatively affect the rest of the market.
“The best scenario is for creditors to cooperate with one another after a default and agree to liquidate slowly,” Oehmke says. “But that’s unrealistic because every creditor will act in its own best interest.”
Using tools from game theory, Oehmke developed a theoretical model to help understand the factors that drive the dynamics of collateral liquidations, including how quickly creditors are likely to sell collateral, the rate at which the price is likely to move during liquidation and the amount sellers are likely to recoup in a liquidation. Considering these dynamics prior to lending or when faced with a default can help creditors reduce the pressure to sell off assets quickly.
Creditor structure plays an important role in these dynamics. One of Oehmke’s key findings is that the race to sell can sometimes be averted when only one creditor has lent to a financial institution, as might be the case with small institutions that don’t need multiple sources of credit.
But multiple creditors can take on more risk than a single creditor; when a lone creditor is responsible for all of a borrower institution’s collateral assets, a default can increase the creditor’s liabilities, weakening its balance sheet. Unless the creditor has an otherwise strong balance sheet that can compensate for the decreased value of the collateral assets, affording the creditor leeway to hold on to them, it will sell quickly, provoking a drop in price before all the assets have sold. Oehmke shows that ultimately, whether a liquidation is more orderly with a single or multiple creditors depends on the nature of the collateral asset and the individual balance sheet strength of the creditors.
Oehmke also concludes that when setting margins for collateral assets, creditors should take into account the total number of lenders, illiquidity of the assets and how likely it is that a financial institution will default. A creditor who lends $800,000, for example, may consider these factors and conclude that it should require $1 million in collateral assets. With a secure margin, the creditor can hold on to the assets longer, sell them slowly, and remain relatively unaffected as long as the value doesn’t drop below the amount of the initial loan.
“Creditors should consider the amount of risk they can bear during a liquidation should a borrower default,” Oehmke says. “Will they have enough risk-bearing capacity in the event of default?”
Another possible way to prevent a liquidation race is for a firm with a strong balance sheet to step in and buy the troubled assets in bulk, either holding the positions or liquidating them slowly. Last fall, for example, in a deal brokered by the U.S. government, Bank of America averted Merrill Lynch’s default by acquiring it and curtailing a mass sale of its collateral assets. Similarly, last spring, the government intervened and prevented Bear Stearn’s default by brokering its sale to JP Morgan Chase. While both deals have garnered plenty of criticism, it’s likely that the actions averted the kind of massive dislocations and financial market panic seen after the Lehman default.
“Considering the dynamics of collateral sales prior to the default of a financial institution,” Oehmke says, “can help creditors make better risk management decisions and act in a more calculated fashion when they find themselves in a liquidation, preventing or limiting financial loss and spillover effects into the rest of the market.”
Martin Oehmke is assistant professor of finance and economics at Columbia Business School.