Collateralized Debt Networks with Lender Default

Abstract

The Lehman Brothers' bankruptcy triggered the failure of the collateralized debt markets, which was a major contributor of the financial crisis in 2008. Such collateralized debt markets have both collateral price channel and counterparty (borrower and lender) channel of contagion. I propose a general equilibrium network model, which incorporates the two channels of contagion by endogenizing leverage (margin), asset prices, and network formation. Agents face a tradeoff between leverage and counterparty risk. Diversification of counterparty risk generates positive externalities by reducing systemic risk, but comes at the cost of lower leverage. Thus, any decentralized equilibrium is inefficient due to under-diversification. I use this framework to show that the loss coverage by a central counterparty (CCP) exacerbates the externality problem and the introduction of CCP can rather increase systemic risk.

Contagion in debt and collateral markets

“…The closest to this paper is Chang (2021). As in this paper, Chang (2021) analyzes the interaction between the counterparty and price channel of spillovers.…”

“…The closest to this paper is Chang (2021). As in this paper, Chang (2021) analyzes the interaction between the counterparty and price channel of spillovers. The main difference is that the model in Chang (2021) simplifies the borrower default contagion by assuming nonrecourse contracts in order to focus on lender default and network formation.…”

“…Hence, reuse (rehypothecation) of collateral can improve financial stability for a given debt amount and asset holdings. Indeed, reuse of collateral can alter the total cash holdings and network structure as well as the debt amount (Chang, 2021). Such endogenous network formation is beyond the scope of this paper.…”

Collective Moral Hazard and the Interbank Market

“…There is a growing literature which analyzes the endogenous formation of financial networks, including Acemoglu et al (2014), Chang (2019), Di Maggio and Tahbaz-Salehi (2014), Elliot et al (2014), Elliot et al (2018, Erol (2018), Kanik (2019), Leitner (2005), Shu (2019). Our model includes an element of endogenous network formation which depends on a strategic complementarity in banks' portfolio choices.…”

Contagion in Debt and Collateral Markets

“…See https://www.sifma.org/wp-content/uploads/2022/02/SIFMA-Research-US-Repo-Markets-Chart-Book-2022.pdf. 2 InChang (2021), nonrecourse contracts are considered to solve for endogenous network formation. In this paper, we do not attempt to endogenize network formation, however we solve for the networks with full-recourse contracts.…”