Funding Liquidity risk in collaterals: Gregory

[Kavita.bhangdia]

Hi David,

Please can you explain how does funding liquidity risk play a role with collaterals.. You have mentioned a paragraph on page 43 in Chapter 5 of Gregory about this.

Thanks
Kavita

 

[ShaktiRathore]

hi
please see if of any help:
http://www.bis.org/publ/work316.pdf
thanks

 

[brian.field]

While @ShaktiRathore's reference is exactly correct, I offer a short example.

Consider a hedge fund that offered an intermediary a piece of a senior tranche of an ABS CDO as collateral in early 2007; at the time, this paper was deemed "VERY" safe. Then, the credit crisis hit. Assume the hedge fund declared bankruptcy and the intermediary needed to liquidate the ABS CDO paper to be made whole......BUT, the intermediary wasn't able to do so. Or, if able to do so, perhaps it wasn't able to do so without marking down the tranche from par to 20 cents....thus causing a significant loss. This loss would be, primarily, due to the illiquidity (along with some credit deterioration).

 

[brian.field]

now that I reread it, I guess my example isn't really related to "funding" liquidity risk.

As an example, consider the Lehman bankruptcy. As soon as intermediaries smelled blood in the water with Lehman, they started asking for better collateral or in effect, significantly more sever haircuts....and additional margin calls. This created a "funding" liquidity squeeze for Lehman....which then avalanched and ultimately caused their bankruptcy! I forget which reading covers this but I suspect it might be the paper Shakti posted. If I am correct, it is covered in some detain in the OpRisk topic.

 

[Kavita.bhangdia]

Yes I thought so too..just wanted confirmation..
So basically collateral is subjected to both funding and liquidity risk..

Can you please tell me how does a collateral INCREASE exposure..? That is little counterintuitive to me.. Any example ??


Thanks
Kavita

 

[Mkaim]

Yes I thought so too..just wanted confirmation..
So basically collateral is subjected to both funding and liquidity risk..

Can you please tell me how does a collateral INCREASE exposure..? That is little counterintuitive to me.. Any example ??


Thanks
Kavita

Collateral itself has its own volatility if it's not cash, and you have to consider that as well. Basically, if you have a positive and exact same exposure from day 1 to 2 but the collateral you received loses value, all of the sudden you're not fully collateralized and exposure is increased.

 

[brian.field]

Also, collateral rehypothecation can increase exposure - see @Mkaim and my discussion here: https://forum.bionicturtle.com/threads/rehypothecation-risk.9473/#post-41543