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Crises, Liquidity Shocks and Fire Sales at Financial Institutions. Nicole Boyson Northeastern University Jean Helwege University of South Carolina Jan Jindra Menlo College. How Do Financial Crises Cause Recessions?. Empirically, a bad financial system is correlated with worse recessions
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Crises, Liquidity Shocks and Fire Sales at Financial Institutions Nicole Boyson Northeastern University Jean Helwege University of South Carolina Jan Jindra Menlo College
How Do Financial Crises Cause Recessions? • Empirically, a bad financial system is correlated with worse recessions • Bordo and Haubrich (2009), Berger and Bouwman (2010), Bernanke and Gertler (1989) and Bernanke and Lown (1991) • Ivashina and Scharfstein (2010) argue that lending fell sharply in the past recession because the banks were funding constrained • Suggests recession was much worse due to unusually low lending and frozen debt markets • A potential explanation for the link between recessions and financial crises involves funding shortfalls at financial institutions
Liquidity Shocks, Fire Sales, Recessions • Recent theories focus on liquidity shocks as a source of financial crises that create problems for lending and thus the real economy. • Allen and Carletti (2006), Adrian and Shin (2008, 2009), Brunnermeier and Pedersen (2009), Diamond and Rajan (2009), Froot (2009), Geanakoplos (2010), Gromb and Vayanos (2002),Krishnamurthy (2009), Korinek (2009) • Crisis starts when financial firms experience a liquidity shock, and is amplified via asset sales. • Liquidity shock affects banks • Lost funding is dealt with by selling off assets • Asset sales cause price to drop • Losses from fire sales reduce capital • Lower capital drives feedback loop (asset price spiral) • Illiquidity may lead to bank insolvency • Capital shortage leads to pullback in lending that hurts nonfinancial firms and exacerbates recession
Extant Empirical Research • Plenty of empirical studies show support for idea that liquidity shocks lead to asset spirals in financial crises: • Adrian and Shin (2009) show that I-bank growth is related to leverage; Adrian and Brunnermeier (2009) provide evidence on feedbacks and correlations among large financial firms • Gorton and Metrick (2009) and Brunnermeier (2009) point to problems in the repo market, suggesting the banks that relied on short term capital markets funding were hurt most when liquidity shocks hit • Hedge fund studies show that funding liquidity and market liquidity appear to be related. • He, Khang and Krishnamurthy (2010), Ben-David, Franzoni, and Moussawi (2010), Billio, Getmansky, and Pellizon (2009), Sadka (2010), and Aragon and Strahan (2009)
Extant Empirical Research • Why would banks put themselves in such a precarious situation? • Beltratti and Stulz (2009) show that commercial banks that got into the most trouble in the last crisis were those most focused on maximizing shareholder value • Is exposure to liquidity shocks an undesirable side effect of optimal bank strategy? • Previous research suggests there are alternative ways to deal with liquidity shocks besides fire sales • Greater use of deposits (Gatev, Schuermann and Strahan (2009) • Equity issuance (Berger, DeYoung, Flannery, Lee, and Oztekin (2008) and Cornett and Tehranian (1994)) • “Cherrypick” assets (Beatty, Chamberlain and Magliolo (1995)) • Discount window (Furfine (2001))
Extant Empirical Research • Previous literature also provides some evidence that liquidity shocks do not amplify price spirals: • Kashyap and Stein (2000): Lending at largest banks doesn’t fall when money is tight, due to better access to capital markets. • Gatev and Strahan (2006): Deposit flows increase in troubled times, acting as a hedge when demand for bank credit rises. • He, Khang and Krishnamurthy (2010): Commercial banks were rare among financial firms in their purchases of MBS in the last crisis. • Demsetz (1993, 2000): Loan sales go down in bad times. • Cao, Chen, Liang and Lo (2009): Hedge funds seem to be able to time market liquidity • Anand, Irvine, Puckett and Venkataraman (2010): institutions sell off liquid assets in a crisis • Ambrose, Cai, Helwege (2009): Prices don’t fall just because an asset is sold
Research Question What is the role of liquidity shocks for financial institutions during financial crises? • Theory suggests that the more heavily a firm relies on funding from the capital markets, the more likely it will need to sell assets into a falling market. • Hedge funds should be more affected than investment banks (IB) and commercial banks (CB), and IB would be more affected than CB. • Large commercial banks that use the repo market and commercial paper should suffer more than banks with strong deposit networks. • Hedge funds with short lockups and large outflows should suffer the most. • When liquidity shocks occur, cheaper alternatives to fire sales used first: • Deposits and discount window for CB • Equity issuance or dividend cuts for CB and IB • Sale of assets that are least affected by crisis (cherrypicking to boost equity) • Sale of liquid assets rather than illiquid ones
Research Design • Identify crises and investigate changes in funding and assets at commercial banks (CB), I-banks (IB) and hedge funds: • Does financing for IB and CB decline in a crisis? • Do IB and CB engage in fire sales? • When assets are sold, which ones? • How do hedge funds respond to the crisis? • During crises, how much do funds with short lockup periods and large redemption requests (constrained funds) sell off compared to funds with long lockup periods and small redemption requests (unconstrained funds)
Data • Commercial bank data from Compustat bank quarterly data 1980; I-bank data from 1980 but publicly traded I-banks limited in early part of sample • Only largest commercial banks (about 100 each quarter) • Hedge funds identified from TASS, matched with funds that report with13-f forms to SEC (Thomson-Reuters) • 13-f reports are quarterly • Start with data in 1998 to keep sufficient sample size • Identify crises from NBER recessions, bank failures, stock returns, flight to quality, known events like LTCM
Write-downs vs Fire Sales • FAS115 (1993), gain/loss account reflects actual sales of securities and write-downs of “available-for-sale” securities that are “other-than-temporarily-impaired” (OTTI). Reported in footnotes. • SEC filings in 2007 and 2008: • 2007: Gain of $300 million = $1.9 billion gain on sales and -$1.6 billion OTTI write-downs • 2008: Loss of $1.5 billion: $9.8 gain on sales and -$11.3 billion in OTTI write-downs • Also examine other gains and losses: net realized gains of $3.0 billion in 2007 and $1.1 billion in 2008 • Together, these results provide strong evidence of cherrypicking in recent crisis.
Cherrypicking Bank Divested Asset Gain ($b.) Date JP Morgan Chase Paymentech Solutions 1.0 12/08 (credit card processor) Citigroup German banking operations 3.9 12/08 Merrill Lynch Bloomberg, L.P. 4.3 12/08 Bank of America Marsico Capital Management 1.5 12/07 PNC Hilliard Lyons 0.1 6/07 (asset management)
Characteristics of Stocks held by Hedge Funds
Conclusion • Liquidity shocks do not appear to trigger financial crises: • Debt issuance does not fall in crises at commercial banks and I-banks • ST debt (repo borrowing) does not drop off a cliff • Deposits rise – deposits are likely cheapest funding alternative • Equity issuance increases • Creditworthiness appears to affect borrowing and deposits in a crisis • Fire sales do not appear to amplify crises • Assets do not drop on average and few banks only sell assets • Asset declines likely reflect revaluations • Strong evidence of cherrypicking in most recent crisis • Constrained hedge funds buy more stock!
