The Growth of Finance, Financial Innovation, and

Systemic Risk

Lecture 4

BGSE Summer School in Macroeconomics, July 2013

Nicola Gennaioli, Universita’ Bocconi, IGIER and CREI

Fire Sales2

Fire sale: term used in the 19th century describing firms selling smoke-damaged goods at cut-rate prices in the aftermath of a fire

Fire sales of financial assets: “forced” sale of an asset at a dislocated price.

Fire Sales and Financial Crises

3

Fire sales arguably played an important role in the unraveling of financial markets during the recent crisis (and also other crises in the past):

“An initial fundamental shock to associated with the bursting of the housing bubble and deteriorating economic conditions generated losses for leveraged investors including banks…The resulting need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales”

U.S. Treasury, 2009

Modeling fire Sales4

One main reason for fire sales is collateralized lending: when the borrower cannot repay, the lender satisfies his claim by liquidating the collateral

If the collateral is an idiosyncratic, illiquid asset, fire sales are likely. But what if collateral is a generic financial asset?

In this case, the asset is likely to be sold at fire sale if: Some market participants (specialist) value the

asset a lot. These market participants can’t buy because they

are themselves financially distressed Fire sales can become pervasive in systemic risk

states

Shleifer and Vishny (1992)

An entrepreneur borrows money to buy an asset (e.g. airplane) from a lender, used to generate cash flows.

The optimal debt contract involves short term debt, so as to discipline the borrower.

As the entrepreneur suffers an adverse shock, the asset (airplane) is sold on the market.

The are some industry specialists (other airlines), but if the shock is common (e.g. terrorism induced decline in travel) these specialists are impaired, too.

The asset (airplane) may is bought by low valuation outsiders

5

Two Questions6

Why does the lender sell rather than holding on to the asset? The fire sales value may be enough to repay the

lender’s claim or the lender may be unwilling to wait (unclear when the price will go back to fundamental)

Why doesn’t the borrower negotiate with the seller, by bribing him not to liquidate? The borrower is financially constrained and thus does

not have enough fresh funds to pledge to the lender (and cannot borrow more owing to debt overhang problems)

A Model of Fire Sales and Leverage

7

From Geanakoplos (2009)

Two periods t =0,1, agents are patient, no short sales

There is one asset that at t = 1 pays off either 1 (in good state) or 0,2 (in bad state).

Continuum 1 of agents, each of which is endowed with one share of the asset and one unit of t = 0 consumption

Agents are heterogeneous with respect to the probability h they attach to good state. h is uniform in [0,1].

8

9

Some agents (high h) are optimists, others (low h) are pessimists

Optimists (high h) are the natural buyers: they value the asset more than the pessimists

Average valuation of the asset:

Questions: What is the equilibrium price if we allow the asset

to be traded? What is the equilibrium price if we allow the asset

to be traded and also leverage?

1

06,0)2,0)(5,0()5,0()2,0)(1( dhhh

Exchange Equilibrium (I)

10

Optimists want to buy shares from pessimists Pessimists prefer to consume today for sure

than to hold a risky claim on future consumption

At price p, the sellers are agents such that:

As a result, the supply of the asset is The demand of the asset is

At the equilibrium where demand equals supply we have:

8,0

2,0

ph

8,0/)2,0( ppp )8,0/()1(

67,0p

Exchange Equilibrium (II)11

The price is above the average valuation because optimists end up holding more than one unit of the asset

The marginal agent is identified by:

The 40% most optimist agents hold all the assets

*h

6,067,0)1)(2,0( *** hhh

Exchange with Leverage (I)12

Everybody agrees that the worst outcome is 0.2. As a result, optimists can pledge to borrower a collateral of 0,2 for each unit of the asset they hold. More subtle point: this is the optimal form of

borrowing: risky debt involves pessimists holding a claim they value less than optimists, so this is not optimal

Each buyer now can buy x units provided . This implies that he can buy at most:

Units of the asset

2,0

)2,0(1*

p

x

)2,0)(1(1 xpx

Exchange with Leverage (II)

13

At price p, the sellers are again the agents such that:

As a result, the supply of the asset is

The demand of the asset is:

At the equilibrium where demand equals supply we have:

The price is higher than 0,67 obtained without leverage

8,0

2,0

ph

8,0/)2,0( p

)8,0/()1(* px

75,0p

Exchange with Leverage (III)14

The price is above the no leverage case because by levering up, very optimistic agents drive up price.

The marginal agent is identified by:

The 32% most optimistic agents hold all the assets. Leverage concentrates the asset on the optimists.

Leverage per unit is: 0,75/(0,75 – 0,2) = 1,36

*h

86,075,0)1)(2,0( *** hhh

Leveraging and Deleveraging

15

News signals come in at both time 1 and time 2; can be either U (“up”) or D (“down”). Agents borrow short term

Asset pays off 1 unless news sequence is worst-case DD; in this case, it pays 0.2

Continuum of agents uniformly distributed on interval [0, 1].

Agent h believes prob of signal being U at any point = h.

Based on average opinion, value of the asset at time 0 is equal to (0.75 + 0.25*0.2) = 0.80. After one D signal at time 1, the average value is

0.60, as before.

16

17

Analysis of Price Drop18

Three effects depress prices at t = 1 after D: The news itself: good state is less likely. Most optimistic buyers are wiped out. Asset must

now be held by those who are less optimistic. Less leverage is (endogenously) available to

investors

Leverage is: .95/(.95-.69) = 3.7 at t = 0 .69/(.69-.20) = 1.41 at time t = 1 after D Alternatively, there are more investors at time

1: 26% of population is long, vs. 13% at time 0.

Innovation and Speculation19

From Simsek (2012)

Two traders of an asset which pays off at 1 with quadratic preferences:

U(c) = E(c) - (θ/2)var(c)

Trader i is endowed with wealth wi, which is stochastic and captures the trader’s background risk

Traders can invest in risky assets

Sources of risk and Endowment20

Sources of risk: two uncorrelated random variables

The agents face a combination of these two risks:

Endowment of the agents: perfectly negatively correlated:

Without assets, agents bear their endowment risk

21,vv

21 vvv

vewvew 21

One Asset, No Disagreement

21

Introduce and asset perfectly correlated with the traders’ endowment

Traders’ equilibrium portfolio is for agent 1 to sell the asset, for agent 2 to buy it. The resulting consumption is:

Endowment risk is fully insured

211 vvva

ecec 21

One Asset, Disagreement (I) 22

Traders agree on the second source of risk , which is normally distributed with mean zero and variance 1.

Traders disagree on the first source of risk . Agent 1 optimist, and thinks its average is , agent 2 is pessimist, and thinks its average is .

When asset 1 is traded, the optimist buys a quantity

of it, the seller sells a quantity

of it

2v

1v0

0

)1( 2

)1( 2

One Asset, Disagreement (II) 23

The traders’ consumption in equilibrium is equal to:

If >1, the introduction of the new asset increases the variance of the agents’ consumption

The new assets allows agents to take opposite positions on the source of risk they disagree, making their wealth riskier And none of the agent is right!!

)1( 2

)1(

)(2

211

vv

ec)1(

)(2

212

vv

ec

Two Assets, Disagreement (I) 24

Now add another asset on the source of risk where traders have common beliefs, namely:

At the optimum, agents 1 sells asset 2 while agent 2 buys it. Agents insure against the common source of risk, over which they have symmetric beliefs.

The agents can still trade the source of risk in which they disagree, betting on their beliefs. What is the allocation?

22 va

Two Assets, Disagreement (II) 25

The traders’ consumption in equilibrium is equal to:

The introduction of the second asset further increases risk!! Hedge more-bet more effect: the more the

agents can hedge against the risks on which their beliefs agree, the more they bet on the sources of risk over which they disagree

11 vec

12 vec

Conclusions26

Asset fire sales can be responsible for dramatic collapse in asset prices below their fundamental value

Fire sales are more severe the more levered are the high valuation buyers in good times

Innovation can facilitate the ability of optimists to take large bets by allowing them to bet more and hedge their risks

Important implications for the behavior of highly levered intermediaries during crises