The Maturity Rat Race - Princeton University · Many Rollover Dates: The Maturity Rat Race Up to...
Transcript of The Maturity Rat Race - Princeton University · Many Rollover Dates: The Maturity Rat Race Up to...
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The Maturity Rat Race
Markus Brunnermeier, Princeton University
Martin Oehmke, Columbia University
August 4, 2010
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Is There Too Much Maturity Mismatch?
I Households have long-term saving needs
I Banks have long-term borrowing needs
⇒ Why is intermediary borrowing so short-term?
Rationale for ‘beneficial’ maturity mismatch:
I Diamond and Dybvig (1983)
I Calomiris and Kahn (1991), Diamond and Rajan (2001)
There may be excessive maturity mismatch in the financial system
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This Paper
A financial institution can borrow
I from multiple creditors
I at different maturities
Negative externality can cause excessively short-term financing:
I shorter maturity claims dilute value of longer maturity claims
I depending on type of interim information received at rollover dates
Externality arises
I for any maturity structure
I particularly during times of high volatility (crises)
Successively unravels all long-term financing: ⇒ A Maturity Rat Race
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Outline
Model Setup
One Rollover Date
I Two Simple Examples
I The General Case
Multi-period Maturity Rat Race
Discussion
Related Literature
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Model Setup: Long-term Project
Long-term project:
I investment at t = 0: $1
I payoff at t = T : θ ∼ F (·) on [0, θ̄]
Over time, more information is learned:
I st observed at t = 1, . . . ,T − 1
I St is sufficient statistic for all signals up to t: θ ∼ F (·|St)I St orders F (·) according to FOSD
Premature liquidation is costly:
I early liquidation only generates λE [θ|St ], λ < 1
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Model Setup: Credit Markets
Risk-neutral, competitive lenders
All promised interest rates
I are endogenous
I depend on aggregate maturity structure
Debt contracts specifies maturity and face value:
I can match project maturity: D0,T
I or shorter maturity D0,t , then rollover Dt,t+τ etc.
I lenders make uncoordinated rollover decisions
All debt has equal priority in default:
I proportional to face value
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Model Setup: Credit Markets (2)
Main Friction: Financial institution has opaque maturity structure
I simultaneously offers debt contracts to creditors
I cannot commit to aggregate maturity structure
I can commit to aggregate amount raised
An equilibrium maturity structure must satisfy two conditions:
1. Break even: all creditors must break even
2. No deviation: no incentive to change one creditor’s maturity
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Outline
Model Setup
One Rollover Date
I Two Simple Examples
I The General Case
Multi-period Maturity Rat Race
Discussion
Related Literature
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Analysis with One Rollover Date
For now: focus on only one possible rollover date, t < T
Outline of thought experiment:
I Conjecture an equilibrium in which all debt has maturity T
I Calculate break-even face values
I At break-even interest rate, is there an incentive do deviate?
Denote fraction of short-term debt by α
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A Simple Example: News about Default Probability
θ only takes two values:
I θH with probability p
I θL with probability 1− p
p random, revealed at date t
If all financing has maturity T :
(1− p0) θL + p0D0,T = 1, D0,T =
1− (1− p0) θL
p0
Break-even condition for first t-rollover creditor:
(1− pt)Dt,T
D0,TθL + ptDt,T = 1, Dt,T =
1− (1− p0) θL
θLp0 + (1− θL) pt
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Illustration: News about Default Probability
Deviation payoff:
∂Π
∂α
∣∣∣∣α=0
= E [ptD0,T ]− E [ptDt,T ] > 0?
Product of two quantities matters:
I Promised face value under ST and LT debt (left)
I Probability that face value is repaid (right)
0.0 0.2 0.4 0.6 0.8 1.0p
0.5
1.0
1.5
2.0
2.5
3.0
Face Value
Dt,T HStL
D0,T
0.2 0.4 0.6 0.8 1.0p
0.2
0.4
0.6
0.8
1.0
Repayment Probability
pt
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Illustration: News about Default Probability
Multiplying promised face value and repayment probability:
0.0 0.2 0.4 0.6 0.8 1.0p
0.5
1.0
1.5
Marginal Cost
Long-term financing
Rollover financing
B
A
Note:
A > B implies rolling over cheaper in expectation
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A Simple Example: News about Recovery Value
θ only takes two values:
I θH with probability p = 1/2
I θL with probability 1− p
Low cash flow θL random, revealed at date t
If all financing has maturity T :
1
2D0,T +
1
2E[θL]= 1, D0,T = 2− E
[θL]
Break-even condition for first t-rollover creditor:
1
2Dt,T +
1
2
Dt,T
D0,TθL = 1, Dt,T
(θL)= 2
2− E[θL]
2− E [θL] + θL
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Illustration: News about Recovery Value
Deviation payoff:
∂Π
∂α
∣∣∣∣α=0
=1
2D0,T − 1
2E [Dt,T (θ
L)] > 0?
Product of two quantities matters:
I Promised face value under ST and LT debt (left)
I Probability that face value is repaid (right)
0.0 0.2 0.4 0.6 0.8 1.0Θ
L
1.2
1.4
1.6
1.8
2.0
Face Value
Dt,T HStL
D0,T
0.2 0.4 0.6 0.8 1.0Θ
L
0.2
0.4
0.6
0.8
1.0
Repayment Probability
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Illustration: News about Recovery Value
Multiplying promised face value and repayment probability:
0.0 0.2 0.4 0.6 0.8 1.0Θ
L
0.6
0.7
0.8
0.9
1.0
1.1
Marginal Cost
Long-term financing
Rollover financing
B'
A'
Note:
A′ < B ′ implies rolling over more expensive in expectation
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What is going on? Interim Information Matters!
Rollover face value Dt,T (promised interest rate)
I is endogenous
I adjusts to interim information
Interim Signal Dt,T default no default
Negative high LT creditors lose no effect
Positive low LT creditors gain no effect
If default sufficiently more likely after negative signals
⇒ LT creditors lose on average
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General One-Step Deviation
Extend to:
I general payoff distribution
I start from any conjectured equilibrium that involves some amount of
LT debt
Assumption 1: Dt,T (St)
∫ ∞
D̄T (St)
dF (θ|St)︸ ︷︷ ︸repayment probability
is weakly increasing in St
I Guarantees signal has sufficient effect on default probability
Proposition: One-step Deviation. Under Assumption 1, the unique
equilibrium is all short-term financing (α = 1).
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Outline
Model Setup
One Rollover Date
I Two Simple Examples
I The General Case
Multi-period Maturity Rat Race
Discussion
Related Literature
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Many Rollover Dates: The Maturity Rat Race
Up to now: focus on one potential rollover date
I Assumed everyone has maturity of length T
I Showed that there is a deviation to shorten maturity to t
This extends to multiple rollover dates
I Assume all creditors roll over for the first time at some time τ < T
I By same argument as before, there is an incentive to deviate
I In proof: For τ < T replace final payoff by continuation value
⇒ Successive unraveling of maturity structure
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The Maturity Rat Race: Successive Unraveling
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The Maturity Rat Race: Successive Unraveling
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The Maturity Rat Race: Successive Unraveling
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The Maturity Rat Race: Successive Unraveling
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The Maturity Rat Race: Successive Unraveling
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The Maturity Rat Race: Successive Unraveling
Assumption 2: Dt−1,t (St−1)
∫ ∞
S̃t
dG (St |St−1)︸ ︷︷ ︸prob of rollover at t
is increasing in St−1 ∀t
I Guarantees signal has sufficient effect on rollover probability at next
rollover date
Proposition: Sequential Unraveling. Under Assumption 2, successive
application of the one-step deviation principle results in unraveling of the
maturity structure to the minimum rollover interval.
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Outline
Model Setup
One Rollover Date
I Two Simple Examples
I The General Case
Multi-period Maturity Rat Race
Discussion
Related Literature
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Rat Race Causes Inefficiencies
Excessive Rollover Risk
I Project could be financed without any rollover risk
I Rat race leads to positive rollover risk in equilibrium
Underinvestment
I Creditors rationally anticipate rat race
I NPV of project must outweigh eqm liquidation costs
I ⇒ some positive NPV projects don’t get financed
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Rat Race Strongest During Crises
Rat race stronger when more information about default probability is
released at interim dates
I ability to adjust financing terms becomes more valuable
⇒ Volatile environments, such as crises, facilitate rat race
Explains drastic shortening of unsecured credit markets in crisis
I e.g. commercial paper during fall of 2008
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Commercial Paper Issuance 2008
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Seniority, Covenants
Priority for LT debt and covenants may limit rat race
Can reduce externality of ST debt on LT debt
I Seniority for LT debt
I Restrictions on raising face value of ST debt at t < T
But:
I by pulling out early, ST creditors may still have de facto seniority
I Particularly for financial institutions, covenants are hard to
write/enforce
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Outline
Model Setup
One Rollover Date
I Two Simple Examples
I The General Case
Multi-period Maturity Rat Race
Discussion
Related Literature
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Related Literature
‘Beneficial’ Maturity Mismatch
I Diamond and Dybvig (1983)
I Calomiris and Kahn (1991), Diamond and Rajan (2001)
Papers on ‘Rollover Risk’
I Acharya, Gale and Yorulmazer (2009)
I He and Xiong (2009)
I Brunnermeier and Yogo (2009)
Signaling Models of Short-term Debt
I Flannery (1986)
I Diamond (1991)
I Stein (2005)
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Conclusion
Equilibrium maturity structure may be efficiently short-term
I Contractual externality between ST and LT creditors
I Maturity Rat Race successively unravels long-term financing
This leads to
I too much maturity mismatch
I excessive rollover risk
I underinvestment
Not easily fixed through covenants or seniority for LT debt
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Extra Slides
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A Simple Example: News about Default Probability
θ only takes two values:
I θH = 1.5 with probability p = 0.8
I θL = 0.6 with probability 1− p = 0.2
p updated at date t to pt = 0.8± 0.1
If all financing has maturity T :
(1− p0) θL + p0D0,T = 1, D0,T = 1.1
Break-even condition for first t-rollover creditor:
(1− pt)Dt,T
D0,TθL + ptDt,T = 1, Dt,T =
1.047 if pt = 0.9
1.158 if pt = 0.7
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Illustration: News about Default Probability
Deviation payoff:
∂Π
∂α= p0D0,T − E [ptDt,T (pt)] > 0?
Product of two quantities matters:
I Promised face value under ST and LT debt
I Probability that face value is repaid
∂Π
∂α= 0.8 ∗ 1.1− 0.5 ∗ (0.9 ∗ 1.047)− 0.5 ∗ (0.7 ∗ 1.158) = 0.0033 > 0
⇒ Deviation profitable
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A Simple Example: News about Recovery Value
θ only takes two values:
I θH = 1.5 with probability p = 0.8
I θL = 0.6 with probability 1− p = 0.2
Low cash flow θL random, updated at date t: 0.6± 0.1
If all financing has maturity T :
(1− p)E[θL]+ pD0,T = 1, D0,T = 1.1
Break-even condition for first t-rollover creditor:
(1− p)Dt,T
D0,TθL + pDt,T = 1, Dt,T =
1.078 if θL = 0.7
1.112 if θL = 0.5
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Illustration: News about Recovery Value
Deviation payoff:
∂Π
∂α= pD0,T − pE [Dt,T (θ
L)] > 0?
Product of two quantities matters:
I Promised face value under ST and LT debt
I Probability that face value is repaid)
∂Π
∂α= 0.8 ∗ 1.1− 0.5 ∗ (0.8 ∗ 1.078)− 0.5 ∗ (0.8 ∗ 1.122) = −0.0003 < 0
⇒ Deviation not profitable
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Inefficiency 1: Excessive Rollover Risk
I Project could be financed without any rollover risk
I Rat race leads to positive rollover risk in equilibrium
⇒ Clearly inefficient
Corollary: Excessive Rollover Risk. The equilibrium maturity structure
(α = 1) exhibits excessive rollover risk when conditional on the worst
interim signal the expected cash flow of the project is less than the initial
investment 1, i.e.∫ θ̄
0θdF
(θ|SL
t
)< 1.
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Inefficiency 2: Underinvestment
Creditors rationally anticipate rat race:
I NPV of project must outweigh eqm liquidation costs
I ⇒ some positive NPV projects don’t get financed
Corollary: Some positive NPV projects will not get financed. As a
result of the maturity rat race, some positive NPV projects will not get
financed. To be financed in equilibrium, a project’s NPV must exceed
(1− λ)
∫ S̃t(1)
SLt
E [θ|St ] dGt (St) .