Fire Sales in Frozen Markets

IMF Working Papers, May 6, 2019

Source details

Existing models of fire-sale struggle to explain the collapse in the price of subprime mortgage-backed securities (MBS) during the Financial Crisis of 2008.
Fire-sales can occur even when there is a relatively sizable pool of natural buyers and in the absence of asymmetric information, driven by a coordination failure among buyers.
Buyers’ waiting to trade at a lower price tomorrow can lead to a collapse in the price and trade volume today.
When trade is decentralized and participation is endogenous, a medium level of asset demand and liquidity needs that are expected to increase over time create complementarity among buyers’ decisions to wait.
This complementarity makes competitive markets prone to coordination failures and fire-sales accompanied by a collapse in trade volume.
Fire-sales in this setup may be inefficient.

Decentralized trade with endogenous participation is the core environment analyzed.
Complementarity among buyers’ waiting decisions:
- Buyers expect liquidity needs to increase over time.
- Medium asset demand combined with rising liquidity needs generates incentives for buyers to delay purchase.
- Delayed purchasing by multiple buyers reduces current demand, producing lower current prices and lower trade volume.
The resulting equilibrium can be a "fire-sale equilibrium" characterized by simultaneous price collapse and volume collapse even without asymmetric information or few natural buyers.

The paper discusses various policy options to eliminate the risk of fire-sales in the described setup.
Policy options are evaluated in the context of:
- Preventing coordination failures among buyers.
- Mitigating incentives to wait for lower prices when participation is endogenous.
- Addressing market decentralization features that facilitate complementarity in waiting decisions.

Subject: Asset and liability management, Asset liquidity, Asset prices, Financial markets, Liquidity, Prices, Securities markets
Keywords: Asset liquidity, asset market, asset Markets1, asset price, Asset prices, decentralized asset Markets1, equilibrium price, fire-sale equilibrium, inefficient fire-sale, Liquidity, price impact, Securities markets, WP

Ehsan Ebrahimy. "Fire Sales in Frozen Markets", IMF Working Papers, May 6, 2019.