Repo haircuts buffer lenders against default when bond prices fall

Evidence

The chief risk to B is if A defaults in a situation in which the price of the bond has fallen, but B can mitigate this risk by imposing a “haircut,” in other words lending less than the market price of the bond. In the markets within which Salomon and LTCM operated, haircuts of 2 percent were standard for long duration U. S. Treasury bonds: in other words, B would lend A only 98 percent of the bond’s market price. Haircuts, however, vary with market conditions, with the type of and maturity date of the security, and with B’s assessment of the likelihood of A defaulting. — Donald MacKenzie, An Engine, Not a Camera, 1292

Categorization

• DEFINE: Practical definition of ‘haircut’ grounded in the specific case of repo lending.
• XREF: connects to: A repo is a collateralized loan using the security as pledge — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1290; Repo rate runs below Libor because bonds serve as collateral with a haircut. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1298

Broader Connections

• Repo rate runs below Libor because bonds serve as collateral with a haircut. #expands (0.85) — Donald MacKenzie, An Engine, Not a Camera, 1298