How Repos Work - Introducing The “Haircut”

Now that we know how a Repo transaction actually works (read my previous post "How Repos Work - Some Uncomplicated Excel Sheet Indulgence”), we’re ready to talk about “haircuts”.

While these haircuts are certainly NOT the kind your stylist gives you, I’d imagine they have the same re-assuring impact on repo buyers as my pixie cut has on me (I look like a homeless teenage boy without it).

Think I’m embellishing?

Allow me to present Exhibit A.

Homeless teenage scamp or kooky mad professor?? Hmmm......I can never quite decide.

But I digress.

The hero of this post is the “haircut” that repo buyers (lenders) impose on the market price of collateral securities in order to protect themselves in case of a default by the seller (borrower). Lets assume that the buyer imposes a haircut of 2% on collateral securities whose market value is Rs 50 crores. This means that the buyer will pay the seller 98% of the market value i.e. Rs 49 crores in cash for the securities. At the end of the Repo term, the seller will return the Rs 49 crore to the buyer along with the repo interest on this amount, while the buyer will return the securities worth Rs 50 crore in market value (assuming their price hasn’t changed) back to the seller.  

In a regular repo transaction (sans haircut), the seller would have paid the buyer the full market value of Rs 50 crore in the first leg of the repo transaction. The reason many repo buyers insist on a haircut is to protect themselves from any loss they may incur when they try and sell the collateral securities in case of a default by the seller.

In the example above, lets assume that the seller defaults while the price of the collateral securities falls to Rs 49.2 crores during the term of the repo. In such a situation, due to the cushion of the haircut, the buyer can still sell the securities and make a maximum return of Rs 20 lakh (Rs 49.2 – 49.0 crore) on the deal – the actual return will be less due to transaction costs. If the price of the securities falls to Rs 49 crores, the buyer may at least prevent a loss. 

Besides the price volatility of collateral securities, there are other risks that a “haircut” is designed to protect the seller against, such as:

1)   Liquidity risk: difficulty in liquidating securities without loss in value (finding buyers of sufficient quantity, market impact of big sales etc.)

2)  Legal risk: delay in selling of securities due to litigation challenging the right of the buyer to sell collateral securities post default.

Now that we understand Repo haircut basics, lets do what we love best - a little real-world math! * nerd grin *

The excel sheet below depicts a regular Repo Transaction (without a haircut).  It’s quite self-explanatory.

The sheet below shows the same Repo transaction with a 2% haircut.

The difference between both worksheets is that for the same face value (Rs 50 crore) and market value  (Rs 56.17 crore) of collateral bonds, sans haircut the buyer pays the full market value (Rs 56.17 crore) to the seller, while with a 2% haircut, he pays 98% of the market value of the bonds (Rs 55.04 crore) to the seller. In both cases, the buyer earns 6% in annualized repo interest.

Lets now see how the haircut protects buyers in case of a default where the collateral securities lose market value. Let’s assume the clean price (excludes accrued interest) of the collateral bonds falls from Rs 109 to Rs 108. The worksheet below shows that without the haircut, the buyer will loss money (~Rs 34 lakhs) and make a negative return of 15.8% annualized. With the 2% haircut however, the buyer will make a big return (36.4% annualized) despite the fall in price. Note: this is just an example – potential profits / losses are seldom this big.

The price of the collateral bonds will have to fall to below Rs 106.44 (from Rs 109.0) for the buyer to make a loss with a 2% haircut. See worksheet below. 

Despite my love-affair with excel sheets, I'm beginning to feel like we'd had enough of them for one post. Also, it's time for me to go to the salon. Ciao.