Haircut (finance)

In finance, a haircut is the difference between the market value of an asset used as loan collateral and the value ascribed to that asset when used as collateral for that loan (i.e. an ascribed (nominal) reduction to the value of that asset, when it is used as collateral).[1] The amount of the haircut reflects the perceived risk of the asset falling in value or being sold in a fire sale; the larger the risk is perceived to be, the larger the haircut will be. The lender will, however, still hold a lien for the entire value of the asset. In the event the collateral must be sold to repay the loan (i.e. if the borrower cannot repay the loan), the haircut is intended to protect the lender from recovering less than the full value of the outstanding loan amount from sale of that collateral, even allowing for reductions in the market value.

For example, United States Treasury bills, which are seen as fairly safe, might have a haircut of 10%, while for stock options, which are seen as highly risky, the haircut might be as high as 30%. In other words, a $1000 treasury bill will be accepted as collateral for a $900 loan, while a $1000 stock option might only allow a $700 loan.

Lower haircuts allow for more leverage. Haircut plays an important role in many kinds of trades, such as repurchase agreements (referred to in debt-instrument finance as "repo" but not to be confused with the concept of repossession denoted by that term in consumer finance) and reverse repurchase agreements ("reverse repo" in debt-instrument finance).

In mass media,[2][3][4] as well as in economics texts,[5][6][7] especially post-GFC,[8] the term "haircut" has been used mostly to denote a reduction of the amount that will be repaid to creditors,[4] or, in other words, a reduction in the face value of a troubled borrower's debts,[3][note 1] as in "to take a haircut": to accept or receive less than is owed.[9] In 2012, world media was reporting on the "biggest debt-restructuring deal in history,"[10]:1 which included the "very large haircut" of some "70 percent of par value" of Greek state bonds, in NPV terms.[10]:27

SEC net capital rule

The financial term "haircut" began, and continues to be used, as a reference to valuation discounts applied under the U.S. Securities and Exchange Commission's net capital rule. The net capital rule was adopted to provide safeguards for public investors by setting standards of financial responsibility to be met by broker-dealers and requires a broker-dealer to have at all times sufficient liquid assets to cover its current indebtedness. The SEC explained the role of haircuts in calculating net capital in 1967:

In computing "net capital," the rule requires deductions from "net worth" of certain specified percentages of the market values of marketable securities and future commodity contracts, long and short, in the capital and proprietary accounts of the broker or dealer, and in the "accounts of partners." (These deductions are generally referred to in the industry as "haircuts.") . . . The purpose of these deductions from "net worth," is to provide a margin of safety against losses incurred by a broker or dealer as a result of market fluctuations in the prices of such securities or future commodity contracts.[11]

"Haircut" since has been extended to a number of other financial contexts, whenever it is desirable to show that some securities (typically debt securities) are being valued for some purpose at a discount.

ECB use of haircuts

The European Central Bank applies a haircut to all securities offered as collateral. The size of the haircut depends on the riskiness and liquidity of the security offered as collateral.[12]

LTCM and haircut fees

The speculative hedge fund Long Term Capital Management (LTCM) saw spectacular losses and required massive bail outs in 1998. Prior to that it was able to obtain practically next-to-zero haircuts as its trades were considered safe by its lenders. This was likely due to LTCM's clout and the fact that no counterparty had a total picture of the extent of its complex and highly leveraged operations.[13]

As used for exchange-traded products

When used in the context of exchange traded products such as stocks, options, or futures, haircut is used interchangeably with the term margin. It is the amount of capital required by a broker to maintain the positions currently in a trading account. If haircut exceeds the account's capital, the broker can either require additional capital (e.g., margin call), or liquidate positions until the haircut no longer exceeds available capital.

In sovereign debt write-downs

During the Eurozone crisis, and particularly in the context of the Greek financial crisis, the term "haircut" acquired more specifically the meaning of state-debt holders receiving less than par.[10]:27 It's "the market's euphemism for wiping out a large portion of the debt owed to the creditors."[14]

The haircut agreed to by Greek-state debt holders was deemed "voluntary" by the banks' chief negotiator Charles Dallara, although, in order to convince domestic bond holders, the Greek government Greece "made it clear that holdouts would not receive a sweeter deal," while it also declared that if the haircut was not completed, the Greek state would not be able to "further service its debt."[15]

Notes

  1. ↑ Not just state- but also corporate-debt. See "Private equity firm bosses to get $370M windfall in Caesars mess", The New York Post, 22 August 2016

References

  1. ↑ What Does Haircut Mean?
  2. ↑ Safire, William (6 January 2009). "Haircut". The New York Times. Retrieved 3 July 2018.
  3. 1 2 "All Greek to you? Greece's debt jargon explained". BBC. 10 July 2015. Retrieved 3 July 2018.
  4. 1 2 Clinch, Mark (19 August 2015). "Why the IMF is wrong on a Greek debt haircut". CNBC. Retrieved 3 July 2018.
  5. ↑ Brigham, Eugene F.; Houston, Joel F. (2011). Fundamentals of Financial Management. Cengage Learning. ISBN 978-0538477116.
  6. ↑ Moersch, Mathias; Schmidt, Carolin (8 August 2015). "Of Haircuts and Extensions: An Analysis of Greek Government Debt". International Research Journal of Applied Finance. VI: 87–108.
  7. ↑ Blundell-Wignall, Adrian; Slovik, Patrick (February 2011). "A Market Perspective on the European Sovereign Debt and Banking Crisis" (PDF). Financial Market Trends. OECD. 2010 (2): 87–108.
  8. ↑ "Ukraine creditors' debt plan shows bond haircut inevitable". Reuters. 29 May 2015. Retrieved 3 July 2018.
  9. ↑ "What is a Haircut (in finance)?". Corporate Finance Institute. Retrieved 3 July 2018.
  10. 1 2 3 Liu, Yan; Bergthaler, Wolfgang; Giddings, Andrew; Kosonen, Amanda; Papaioannou, Michael; Grigorian, David; Guscina, Anastasia; Presciuttini, Gabriel; Tsuda, Takahiro; Baqir, Reza (26 April 2013). "Sovereign Debt Restructuring: Recent Developments and Implications" (PDF). Policy Papers. IMF. Retrieved 30 June 2018.
  11. ↑ Net Capital Requirements for Brokers and Dealers - Interpretation and Guide, Release Nos. ASR-107, 34-8024, 32 Fed. Reg. 856, 1967 WL 88933 (Jan. 18, 1967).
  12. ↑ ECB Risk control framework
  13. ↑ Jorion, P. (1999), "Risk Management Lessons from Long-Term Capital Management"
  14. ↑ Parkinson, David (12 July 2011). "Rollover? Haircut? Greece faces ugly choices". The Globe and Mail. Retrieved 3 July 2018.
  15. ↑ Wautelet, Patrick R. (2 July 2013). "The Greek Debt Restructuring and Property Rights: A Greek Tragedy for Investors?" (PDF). University of Liège). Retrieved 3 July 2018.
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