Crises in Repo Markets with Adverse Selection

How can the worsening of a small part of the loan market lead to a crash as well as a prolonged depression in secondary loan prices, bank equity prices, and lending activity? This paper seeks to answer this question. We present a model in which banks issue long-term loans and finance them with repurchase agreements (“repos”) from short-term lenders in order to leverage up their equity. Banks differ in their leveraging ability. Aside from the primary loan market (“loan-generation”), there is a secondary market, where loans can be traded among banks and sold by short-term lenders. Loans differ in quality, but the quality is observable only to the bank currently holding the loan contract. Therefore, the secondary loan market suffers from adverse selection, leading to important repercussions in loan origination. At some random time, the loan pool unexpectedly becomes heterogeneous. This leads to an initial crisis where highly levered banks are forced to sell loans, flooding the market and leading to fire-sale prices. In a numerical example, the initial date-t = 0 “cash in the market” crisis is followed by a prolonged period of subdued secondary loan prices, bank equity prices, and lending activity, in which the low-leverage banks rather than the high-leverage banks dominate the market. ∗Address: Department of Economics, University of Chicago, 1126 East 59th Street, Chicago, IL 60637, U.S.A, email: [email protected]. This research has been supported by the NSF grant SES-0922550. I am very grateful to Andrea Eisfeldt and Brett Green for fruitful discussions and initial exchanges of ideas on this topic, which inspired this paper.