1. 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

2. Fire Sales 2  Fire sale: term used in the 19 th 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.

3. 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

4. Modeling fire Sales 4  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

5. 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

6. Two Questions 6  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)

7. 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].

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9. 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?

10. 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:

11. 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

12. 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

13. 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

14. 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

15. 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.

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18. Analysis of Price Drop 18  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.

19. Innovation and Speculation 19 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 w i, which is stochastic and captures the trader’s background risk Traders can invest in risky assets

20. Sources of risk and Endowment 20 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. 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

22. 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

23. 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!!

24. 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?

25. 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

26. Conclusions 26 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