Martin Oehmke

Liquidating illiquid collateral

Defaults of financial institutions can cause large, disorderly liquidations of repo collateral. This paper analyzes the dynamics of such liquidations. The model shows that (i) the equilibrium price of the collateral asset can overshoot; (ii) the creditor structure in repo lending involves a fundamental trade-off between risk sharing and inefficient “rushing for the exits” by competing sellers of collateral; (iii) repo lenders should take into account creditor structure, strategic interaction, and their own balance sheet constraints when setting margins; and (iv) the model provides a framework to analyze transfers of repo collateral to “deep-pocket” buyers or a repo resolution authority.

A theory of multi-period debt structure

We develop a model of multi-period debt structure. A simple trade-off between the termination threat required to make repayments incentive compatible and the desire to avoid early liquidation determines the number of repayments, their timing, and repayment amounts. For mature firms with risky cash flows, frequent repayments maximize pledgeable income—for example, by rolling over short-term debt. In contrast, for firms with cash-flow growth or significant risk-free cash flows, adding risky repayments can decrease pledgeable income. In some cases, a single risky bullet repayment maximizes pledgeable income, effectively a long-term debt contract.