FINRA Series 16 – Quiz 20

Market liquidity can be expressed in the following three forms:  

• Bid-ask spread 
• Market depth 
• Market resiliency 

Redemption risk: The risk that depositors will withdraw funds from banks, or that investors will redeem their shares (e.g., from mutual funds).  

Margin/haircut funding risk: A risk that arises when a decline in the collateral value of an asset results in an increase in margin requirement, requiring additional equity capital.  

Market depth refers to the number of units of an asset a trader can buy or sell at the current market quote (bid and ask prices). The greater the market depth, the higher the market liquidity.

Market resiliency describes the length of time it will take an asset to regain its price after the price has fallen temporarily.  

Consider two ways of raising funds: (1) selling an asset, or (2) using an asset as collateral to borrow money against it.  

Interaction of funding liquidity and market liquidity can trigger a significant and sudden decline in, or even disappearance of, liquidity, transforming a relatively small shock into a financial disaster.  

To maintain a particular margin (or leverage ratio) in the face of a market decline, an investor may need to sell a portion of assets to ensure that the overall value of the position aligns with the current smaller amount of equity capital and the lower borrowing capacity.  

This situation becomes a loss spiral when the decline leads to a cycle of further price decreases and further forced sales.  

An asset with low market liquidity will sustain a greater loss in a forced sale compared to an asset with higher market liquidity.

Predatory trading— creating a situation in which the seller, already distressed from reducing his position, is forced to sell at an unnaturally low price.  

A margin spiral refers to the forced sale of an asset as a result of an increase in margins or, equivalently speaking, a decline in the leverage ratio.  

To satisfy the increased margin requirements, an investor may have to sell even more assets than under a loss spiral event in which margins and leverage ratios are held constant.  

In an environment of declining prices and general tightening of lending, the necessity to deleverage can produce an ongoing cycle of forced sales, erosion of equity capital, and continued downward pressure on prices.  

Network risk arises as a result of an increase in counterparty credit risk, particularly in an environment of market stress. 

In the first half of 2007, housing prices in the United States started to decline, causing several subprime mortgage lenders to file for bankruptcy and subsequently fail.  

ABCP is the bundling of longer-term debt from mortgages, credit card receivables, and other loans.  

Bank run or “run”. A bank run occurs when depositors withdraw cash from a bank thinking the bank is about to fail.  

A shadow bank is a financial institution other than a regulated depository institution.  

Examples of regulated depository institutions are commercial banks, thrifts, and credit unions.  

Examples of shadow banks are private equity funds, investment banks, hedge funds, mortgage lenders, and insurance companies.  

Repurchase agreements (repos). Repos involve an institutional investor making a short- term deposit of cash with a shadow bank that in turn pays the investor interest on the cash (called the repo rate).  

Haircut: A haircut is the amount of collateral in a repo agreement in relation to a deposit.  

During the financial crisis of 2007-2009, a significant amount of the mortgages in ABCP were subprime mortgages, which subsequently became worthless as MBSs were downgraded. Thus, the ABCP became vulnerable as investors withdrew their money from the shadow banks that were issuing ABCP.  

The main financial market participants in the financial crisis starting in 2007 were institutional investors, such as money market mutual funds, nonfinancial firms, municipalities and state governments, and other large entities investing large amounts of cash with shadow banks.  

The main trigger of the financial crisis, as described by former U.S. Federal Reserve Chairman Ben Bernanke, was the prospect of losses on subprime mortgages.  

The declining ABCP prices resulted in a run on MMFs by institutional and other large investors, which further exacerbated the liquidity crisis as investors withdrew their money.  

When housing prices declined and homeowners defaulted on their mortgage loans, it reduced the value and prices of ABCP (which held mortgages). 

The bankruptcy filing in September 2008 is considered the tipping point in the financial crisis.  

The major impact of Lehman filing for bankruptcy was a run on money market mutual funds starting with Reserve Primary. Reserve Primary contained Lehman commercial paper. After the bankruptcy filing, Reserve Primary was not able to maintain their $ 1 net asset value, which resulted in a run on Reserve Primary by investors. This led to a run on other money market mutual funds, starting a contagion effect that spread to other nonmortgage- related assets and other financial markets.