Issue of Haircuts in US Crisis

What happened in the case of US Financial crisis was also related to haircuts. Normally, At the initiation of loan contract, a Bank takes up a collateral and grants a loan considering the type and the value of the collateral. The value of the loan granted depends on the type of collateral and the Haircut (as explained in my previous post).

Now, with the passage of time, the value of collateral changes depending on market conditions. If the value of collateral decreases to less than the value of the loan, then the bank is in a serious risk if the borrower defaults.

In the case of US financial crises of 2007, there were many mortgage borrowers. People took up mortgage loans. Mortgage loans refer to the loans taken against a real property(mortgage) as collateral. Property prices were rising and so the banks were more than happy to give loans against these collaterals. Haircuts were low as they were supposed to bear low risks. But when the property prices plummeted (because of many reasons, will explain some other day), the value of the collateral decreased to less than the value of the loan and the banks, even if sold the collaterals that they had were not able to recover the loan amounts. (it is a different fact that because of huge supply of these collaterals from banks, prices of collaterals decreased further more and resulted in huge losses to banks)

The concept of Haircuts

Most of the times, Whenever one decides to take a loan, he/she needs to deposit collateral with the bank for the loan to be sanctioned. Not every collateral bears the same amount of risk and so they cannot be valued equally.

Take for example, a 100 rs. treasury bond and a 100 rs. stock of company X. Treasury bond is less risky and so with a 100 rs treasury bond as a collateral, a loan of say 90 (say) can be obtained but whereas with a 100 rs stock as collateral, less than 90 rs loan , say 70 rs loan, can be obtained.

And so the Haircut is 10% for Treasury bond and 30% for a stock (in this example). In more generalized terms, Haircut refers to the percentage by which an assets market value is reduced for the purpose of calculating capital requirements, margins and collaterals.

The whole point of Haircut is to have a collateral which is atleast worth the value of loan at any point of time. And at any point of time, if the value of the collateral decreases to less than the value of the loan, then the lender of the money(say bank) will have the risk of loosing on the money i.e. if the borrower defaults then the bank can only recover money to the value of the collateral and since this value has been decreased to less than the value of loan, the bank looses on some part of the loan.