Post on 26-May-2018
Leverage-Induced Fire Sales and Stock Market Crashes
Kelly Shue
Yale University and NBER
with Jiangze Bian, Zhiguo He, and Hao Zhou
1
• Excessive leverage and fire sales are believed to have been
major contributors to many past financial crises
• 1929 US stock market crash
• 2007/08 financial and housing crises
• 2015 Chinese stock market crash
• Theory of downward leverage spirals
• E.g. Brunnermeier and Pedersen (2009); Geanakoplos (2010)
• Tightened leverage constraints trigger fire sales, which then depress asset prices,
leading to even tighter leverage constraints
• General equilibrium theory featuring positive feedback loop
INTRODUCTION
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• Limited empirical evidence on fire sales, and not in context of leverage with feedback loop
• Coval and Stafford (2007) and Edmans, Goldstein and Jiang (2012): fire sale of equities due to fund outflows
• Ellul, Jotikasthira, and Lundblad (2011): fire sale of downgraded corporate bonds due to regulatory constraints
• Campbell et al. (2011, foreclosed housing); Pulvino (1998, commercial aircraft)
• This paper: Direct evidence of leverage-induced fire sales
• Account-level trading data for margin accounts in Chinese stock market in 2015
• Examine role of shadow-financed margin trading and regulation
• For a study of the leverage amplification effect through the lens of a network contagion framework, see Bian, Da, Lou and Zhou (2017)
• Related to leverage and co-movement/liquidity: Kahraman and Tookes (2016 a,b)
INTRODUCTION
3
• Margin investors heavily sell their holdings when account-level leverage edges toward their maximum leverage limits
• Controlling for stock-date and account fixed effects
• Stocks that are disproportionately held by investors close to receiving margin calls experience high selling pressure and significant short run price declines that eventually reverse
• While regulated brokerage margin accounts owned a greater fraction of market assets, unregulated shadow margin accounts were the major drivers of leverage-induced fire sales
• Regulatory tightening announcements and price limits intensified fire sale pressure (these event studies also aid in identification)
PREVIEW OF RESULTS
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BACKGROUNDChinese stock market crash
• Shanghai Composite Index: Started at around 3100 in Jan 2015, peaked at 5166 on
June 15, then collapsed to 3663 at the end of July
• Chinese stock market: 7.3 Trillion, second in size to US, 85% retail
Two types of margin accounts were popular starting in mid-2014
1. Brokerage-financed margin system
• Similar to US margin trading (initial margin, maintenance margin, etc.)
• Tightly regulated, with minimum initial margin and maintenance margin
2. Shadow-financed margin system
• “Mother account” (looks like a normal unlevered brokerage account with huge assets
and trading volume), linked through software to many levered “child accounts”
• Unregulated grey area: Lower maintenance margin, and larger cross-sectional
variation
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BACKGROUND
The media and government allege that forced fire sale by leveraged accounts
(especially shadow accounts) were the leading cause of the crash
• May 22, 2015: CSRC (China Securities Regulation Commission) announced that brokerage firms should
“self-examine” shadow-financed margin accounts
• June 12 2015: CSRC released draft rules for a future ban on new shadow-financed margin accounts
• What do the data tell us?6
DATA
• Detailed account-level trading during the crisis (May-July 2015)
• Brokerage-financed margin accounts (Brokerage) from a leading brokerage firm,
cleaned sample represents ~5% of market share of brokerage margin service
• Shadow-financed margin accounts (Shadow) from a leading web-based peer-to-
peer lending platform
• Hard to estimate its market share: Best estimate for cleaned sample: ~5%
• Each individual account in both categories
• Daily stock holdings and trading
• Daily assets and debt, leverage = assets/(assets-debt)
• Account maximum allowable leverage (Pingcang Line, 平仓线)
• Stock market data: returns, volume, etc. 7
SUMMARY STATISTICS
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LEVERAGE AND THE MARKET INDEX
• Leverage = Assets/Equity. • Asset-weighted and equity-weighted leverage are quite different!
index, right scale
leverage, left scale
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ACCOUNT-LEVEL EVIDENCE
• ���� : Maximum leverage before the lender takes over
• So-called “Pingcang Line”
• Same for brokerage accounts, varies across accounts for shadow
• ����,� > ���� possible: Cannot sell if stocks hit +/-10% daily limit rule;
possible lender discretion in selling
• Proximity to the Pingcang Line:
• : Dummies for 10 equally-spaced bins by ��,�
,
,
1
1
j t
j tj
le vP
le v
10
,jk tI
ACCOUNT-LEVEL EVIDENCE
• Account-stock-date level regression:
•
• Stock-date fixed effect α�,� and account fixed effect α�
• Identification comes from account �’s time-varying proximity ��,�
• Robust to controls for account j’s recent past returns
• Leverage-induced selling implies that �� increases with �
10
, , , ,1
j j ji t k t i t j i tkk
I
,
Account 's net selling of stock at date
Account 's initial holding of stock at date ji t
j i t
j i t
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ACCOUNT-LEVEL EVIDENCE
• Benchmark: classify accounts with � ≥ 6 as “fire sale accounts”
• Robust to using ��’s as weights to estimate fire sale exposure12
• Suppose proximity determines selling intensity
• Leverage still matters because it amplifies shocks
• For accounts with the same Proximity, those with higher leverage
should sell more aggressively: Their proximity will increase more for
a given drop in asset value
• Shadow sample: add leverage bins and interactions
10 5 5
, , , , , , ,1 1 11 0.6P L PL
k k kj Pj Lj Lj j ji t k t k t k t k t i t j i tk k k
I I I P
LEVERAGE AND PROXIMITY
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LEVERAGE AND PROXIMITY
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MARKET FEEDBACK
• Accounts with high proximity at the start of day t
should sell assets in both up and down market
conditions
• Need to sell to avoid margin call and/or deleverage
• Positive feedback of leverage spiral ⇒ stronger fire
sale effect in market downturn
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MARKET FEEDBACK
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STOCK-LEVEL EVIDENCE
• If stock � is disproportionately held by fire sale accounts, it should be
sold more heavily by these accounts
• Fire sale accounts: accounts with ��,� ≥ 0.6 at the beginning of �
• ����,� is stock �’s fire sale exposure
, , ,controls ji t i t i tFSE
,
Net selling of stock during date in fire-sale accounts
Outstanding shares of stock at date i t
i t
i t
,t
the beginnTotal ing shares of stock in fire-sale accounts at of date
Outstanding shares of stock at date i
i tFSE
i t
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STOCK-LEVEL EVIDENCE
(1) (2) (3) (4)
Net selling of fire sale accounts
Fire Sale Exposure (FSE) 0.0996*** 0.102*** 0.102*** 0.102***
(0.0221) (0.0259) (0.0259) (0.0259)
Return Volatility X X
Size (Market Cap) X X
Turnover X X
Past 10-day cum. return X X
Past 10-day daily return X
Stock FE X X X
Date FE X X X
Observations 116,809 116,809 116,809 116,809
R-squared 0.144 0.186 0.186 0.187
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NET SELLING BY FIRE SALE ACCOUNTS TO TOTAL VOLUME
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• Sample restricted to stocks in the top decile of FSE on each day
• On average, net selling by fire sale accounts corresponds to 0.3% of volume
• Our sample = approximately 5% of margin market
RETURNS AND FIRE SALES
• We predict that stocks with high ��� underperform in the short-run
but not in the long-run
• Two methods
1. Double sort on past returns and ���; long-short strategy based on ���
2. Regression of stock returns from [t, t+X] on ��� with controls for volatility, market
cap, past returns, turnover, stock fixed effect, date fixed effect
• Which stocks fire sale accounts choose to sell is endogenous
• We use each stock’s fire sale exposure: fraction of shares held in fire sale accounts
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PORTFOLIO RETURNS
• Double sort at the start of each day:
1. Sort stocks into quartiles by past returns ��,[����,���]
2. Sort each quartile into deciles by ����,�
• Long the top FSE decile and short the bottom FSE decile
• Leverage induced fire sales predict:
• Negative cumulative abnormal return, that reverts in long run
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AVERAGE PORTFOLIO RETURNS
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BROKERAGE VS SHADOW ACCOUNTS
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FSE: BROKERAGE VS SHADOW
• Fire sale account cut-off � ≥ 0.6; higher leverage ≠ greater proximity
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BROKERAGE VS SHADOW
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BROKERAGE VS SHADOW : SELLING INTENSITY WHEN PROXIMITY EXCEEDS 1
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SHADOW OR BROKERAGE?
• Regress CAR on FSE, constructed using just the Shadow or Brokerage samples• Coefficients represent the change in CAR for a std dev change in FSE• FSE constructed using the Shadow sample has larger effect and explanatory power
1 Day 3 Days 5 Days 10 Days 20 Days 40 Days
FSE of shadow -0.117*** -0.286*** -0.427*** -0.570*** -0.165* 0.0155
SE (0.0311) (0.0659) (0.0894) (0.0947) (0.0433) (0.844)
FSE of brokerage -0.0258*** -0.0883*** -0.0949** -0.0448 -0.0896*** 0.0300
SE (0.0107) (0.0236) (0.0341) (0.0391) (0.0222) (0.0337)
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EVENT STUDY: REGULATION TIGHTENING
• Proposed regulations on shadow system released
• 5/22 (initial announcement) and 6/12 (detailed draft)
• Compare selling intensity in week before and after
announcements
• For both brokerage and shadow accounts
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EVENT STUDY: REGULATION TIGHTENING
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REGULATION: PRICE LIMITS
• Chinese stock market sets a daily price limit for
each stock: absolute return cannot exceed 10%
• Account-level selling intensity of each stock
should be stronger if other stocks cannot be sold
due to stock-specific price limits
• Fraction hitting limit = fractional value of account j’s assets
at the start of day t that consist of stocks that hit price limits
at some point on day t
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REGULATION: PRICE LIMITS
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• Because the fraction of holdings that hit price limits is correlated with returns,we control for the hypothetical portfolio return over day t assuming no trades
A DOUBLE SPIRAL?
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• Loss spiral and margin/haircut spiral
• Figure from Brunnermeier and Pedersen (2008)
PINGCANG LINE: NEW SHADOW ACCOUNTS
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• Pingcang lines never change within an account, but the average Pingcang line of new accounts varies positively with, and leads, the market index
• Ongoing: variation over time in interest rates?
Very few account openings
• Direct evidence of leverage-induced fire sales
• The closer to the maximum allowable leverage, the more investors sell (both
preemptive sales and forced sales)
• The resulting fire sale leads to negative abnormal returns in the short-run
• Feedback loop with market returns
• Regulated brokerage vs. unregulated shadow margin accounts
• Brokerage accounts dominate holdings, but had relatively low fire sale pressure
• Shadow accounts were the major force behind leverage-induced fire sales in
2015 stock market crash
• Regulation triggered and exacerbated fire sales in the short run
CONCLUSION
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RETURNS FOLLOWING FIRE SALES
• Abnormal return is based on CAPM with stock
beta calculated using 2014 data
• ℎ = 1, 3, 5, 10, 20, and 40
• Model prediction
• �� < 0 for small ℎ but �� ≈ 0 for large ℎ
, , ,controlsi t h h i t i t hCAR FSE
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RETURNS FOLLOWING FIRE SALES
• Standard errors clustered at date level• Controls: return volatility, market cap, past 10-day daily and cumulative
returns; turnover; stock fixed effect; date fixed effect
1 Day 3 Days 5 Days 10 Days 20 Days 40 Days
FSE -0.0978*** -0.259*** -0.357*** -0.413*** -0.180*** 0.0338
SE (0.0226) (0.0394) (0.0572) (0.0858) (0.0636) (0.0418)
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LEVERAGE: BROKERAGE VS SHADOW
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(Equity-weighted average – the conservative estimate)
ROBUSTNESS: CONSTRUCTING ��� BASED ON WEIGHTS
• Constructing stock level fire sale exposure ����,�
based on ��
• : number of shares of stock � in account �
• Numerator: weighted sum of shares of stock � in account �; if
account � belongs to group � then the weight is ��
• Again, leverage is measured at the beginning of date t
, ,
,tOutstanding shares of stock at date
j ji t k t kj
i
x IFSE
i t
,ji tx
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PROXIMITY DISPERSION OVER TIME
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