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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

Before the crisis, a repo borrower financed a USD 100 million portfolio of securities with a 2% haircut. In the stress, the haircut rises to 10% on the same portfolio, and the market value is unchanged. By how much does the borrower's required equity funding increase, and what is the systemic implication?

Required equity rises by USD 8 million, from USD 2 million to USD 10 million. Borrowers unable to supply this must shrink positions, causing asset sales and price declines. This can trigger further haircut increases, so margin and haircut spirals amplify systemic stress.

  1. AUSD 8 million; forced deleveraging if the borrower cannot raise fundsCorrect
  2. BUSD 10 million; no systemic implication because values are unchanged
  3. CUSD 2 million; haircuts matter only when prices fall
  4. DUSD 8 million; it reduces procyclicality because borrowers become safer

Explanation

Equity needed rises from 2% x 100 = 2 million to 10% x 100 = 10 million, an increase of 8 million. Borrowers lacking funds must sell assets, which pushes prices down and can raise haircuts again. Higher haircuts therefore amplify stress rather than reducing procyclicality.

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