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Liquidating Illiquid Collateral (Job Market Paper)

by Martin Oehmke of Columbia University

December 2008

Abstract: Defaults of financial institutions can cause large, disorderly asset liquidations. I model the dynamics of such liquidations as a continuous-time trading game, in which following a default, balance-sheet constrained lenders unwind illiquid collateral positions. I show that (i) the equilibrium price of the collateral asset overshoots during liquidation when the lenders who liquidate the collateral asset are sufficiently balance-sheet constrained; (ii) when collateral is spread across multiple lenders this alleviates balance sheet constraints, but can cause inefficient 'racing to the market,' potentially reducing expected liquidation proceeds; (iii) lenders should take into account a borrower's creditor structure and their own balance sheet constraints when setting margins to manage counterparty risk; (iv) the model allows to determine the block price and expected profit at which a 'deep pocket' buyer can purchase the entire collateral position.

Keywords: Illiquidity, Strategic Trading, Prime Brokers, Hedge Funds, Collateralized Lending, Fire Sales, Counterparty Risk Management, Block Trades.

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