Haircut

The term haircut is used to describe the percentage of the difference between the true value of the asset and the guaranteed value.

Author: Kunal Raj
Kunal  Raj
Kunal Raj
I have completed MBA with Finance Specialization with certifications in Business Accounting from CIMA UK, and currently studying to get my Chartered Accountant Certificate form ICAI India.
Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:December 20, 2023

What is a Haircut (in Finance)?

The term haircut is used to describe the percentage of the difference between the true value of the asset and the guaranteed value.

Most are used when obtaining a mortgage loan. Generally, banks do not lend the total amount of collateral. A market value discount or haircut is done depending on the risk and liquidity of the mortgaged property.

This difference between the actual market value of the property and the value set by the bank is applied to act as a shock absorber in case the property’s value falls or the borrower defaults and the bank needs to sell the property in the open market.

For example, Person A wants a loan and puts up his house as collateral. The market value of his house is $20,000,000. The bank after considering A's credit rating and the house’s market value lends only $16,000,000.

The $4,000,000 difference, which is 20% of the market value is the haircut given by the bank as a safety cushion.

Key Takeaways

  • A haircut is used to describe the percentage difference between the actual price and the collateral value of the asset. 
  • The amount of haircut depends on the underlying value of the collateral and how liquid and risky the asset is. 
  • It is implemented to protect the lender against the sudden drop in the market value of the collateralized assets. 
  • The haircut is also sometimes used in the concept to describe the difference between the buying and selling price of a stock share, bond, futures, or options contract.

Use of Haircuts

In finance and banking, a haircut is used to describe the reduction in asset value that a bank gives compared to its actual market value. While mainly used to describe the reduction of collateral value during the loan process, it is also used in other areas of finance.

Following are some contexts where the haircut is used to describe the reduction of the value of the assets.

Haircut during the loan process

When taking any type of loan against any type of collateral, the borrower usually gets a loan amount that is less than the actual market value of the collateralized asset.

For example, a bank will give a loan of $4 million on the collateral of $10 million after calculating all the potential risks. In this case, the bank gives a 60% haircut to the asset's market value.

This discount in the value of an asset is implemented to give the bank some level of protection in case the asset's market value falls or the cost incurred during the liquidation process.

In most countries, banks are legally bound to give some level of a haircut during a loan process to manage their leverage.

During the buying and selling of securities

While making market trades there, whether it be buy or sell, there is always some kind of transaction cost associated. This extra cost incurred during the transaction is also decided as a haircut.

Note

Haircut is sometimes used to describe the difference between the buying and selling price of a stock share, bond, futures or options contract, or any other financial instrument.

In case of bailouts and liquidation

This discount is also done on assets owned by Banks and financial institutions. During the 2008 financial crisis, the government, to boost the economy “bailed out” the banks by giving them loans on their assets.

The loans were given at a discount against the collateral.

Liquidation means to sell an asset and receive cash. When a borrower defaults on their loan, the bank can sell the collateral asset put up by the borrower to recover their money.

But liquidation is not that simple. There are different kinds of charges that the bank incurs, like putting the asset on the market and paying fees and commissions. There are cases when the bank may need cash and will be desperate to sell, even at a discount.

During financial turmoil, the bank may end up losing money as they have to give a higher discount rate compared to the one when they received the asset as collateral. This means that the bank has to bear a haircut on their sale.

Factors influencing Haircut percentage

Many factors affect the amount of discount the asset takes against its market value during a sale or while collateralizing it to get a loan.

Some of the most influential factors that affect the percentage of discounts are describe below.

Type of collateral and its liquidity

The amount of discount varies for different types of assets. For example, a US government bond will have the minimum amount of haircut as it is considered one of the safest assets in the financial market.

A corporate bond of a low-grade company will have a higher discount rate because the risk of default is higher.

Same with the market liquidity of an asset, in the case of more liquid assets, the bank will be able to get it liquidated more easily and with minimal cost. So, the percentage of discount is lower for liquid assets and vice versa.

A highly liquid asset like gold or government bonds will lower the discount percentage compared to any other corporate bond. While companies with an AAA rating will generally have more liquid bonds, they will still get higher discounts when compared to government bonds.

Even in the same asset class, like land, there are different levels of liquidity. For example, land in New York or San Francisco will be easier to sell than land in the middle of the Nevada Desert.

How risky the collateral is?

The amount of discount also depends on how risky the asset is; the higher the risk of loss in value higher the discount rate, and vice versa. Such assets like gold and government bonds of a country like the US will be considered safer than a share of any non-government company.

Price Volatility

An asset's price history also plays a part in determining the discount on collateral. A more volatile asset will have a higher level of discount.

For example, in most collectible assets, there is a wave where the price of a particular collectible, like trading cards, increases, but then after some time, the wave dies down, and the prices again go back to normal.

This type of asset, where there are consent ups and downs, is considered a volatile asset and will get a high percentage of the discount, and on the opposite end, an asset with low volatility, like land, will have a lower discount on its collateralization. 

Credit history of the borrower 

The credit history gives the bank a record of the borrower’s repayment of debt. It can give an idea of how diligently the borrower pays back his borrowings. It is a major factor in deciding the discount rate or haircut the collateral will get.

Poor credit history will mean a hefty discount regardless of the asset's liquidity.

Banks and financial Institutions in the USA determine the discount on the collateral asset and the interest rate to be charged based on the person’s credit score.

Credit scores are in 3-digit numbers, ranging from 300 to 850. A score above 800 is an excellent score, this shows to the bank that a person is very much capable of repaying the loan.

A score between 740 and 799 is also considered very positive. In the third category, scores between 670 to 739 are considered okay and are the lowest score needed to qualify for a loan easily. Finally, anything below this will cause difficulties for the borrower to secure credit.

Example of Haircut

Haircuts are an almost regular process in the financial world. Whenever a loan goes bad or the borrower is struggling the concept of haircut is used during the restructuring of debt to recoup as much loss as possible before delaying the loan bad.

Some of the most well-known uses of haircuts in the financial world are describe below.

Long-Term Capital Management (LTCM)

LTCM was a head fund started in 1994 by John Meriwether who was the former vice chairman and head of bond trading at Salomon Brothers. During its early years, LTCM was successful and returned 21% in its first year of operation.

But in 1998, it lost $4.6 billion due to its high exposure to the 1998 Russian and 1997 Asian financial crises. As the head fund was on the brink of collapse a group of 14 banks under the supervision of the US government invested $3.6 billion to recapitalize LTCM and prevent its bankruptcy.

Partners and other investors in LTCM experienced significant losses when their claim was lowered to 10%, on top of market-driven falls before recapitalization.

Due to the LTCM crisis, the industry introduced a 50% haircut as a standard for the collateralization of stocks for the amount borrowed against a margin trading account.

The firm was dissolved in early 2000.

Greek government-debt crisis

Late in 2009, after the global financial crisis of 2008, the Greek economy plunged into economic crisis, and being a member of the eurozone it had very little power over its monetary policies.

This lack of control over its monetary policies created a situation where it was unable to use the tools that other central banks used during the crisis, making the situation even worse.

Even after multiple rescue attempts by the European banks and IMF the Greek economic crisis lasted till 2017 and still hasn't fully recovered.

During these rescue attempts in 2012, the most significant haircut was given to the bondholders of the Greek government. Both private bondholders and banks had to agree to a voluntary bond exchange.

In this exchange, the holders were given new bonds with a lower face value and longer maturity in exchange for their old bonds. Experts say this exchange gave on average a 53.5% haircut to all the bond investors. 

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Researched and authored by Kunal Raj | LinkedIn

Reviewed and edited by Mohammad Sharjeel Khan | Linkedin

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