A haircut in the financial world is not pleasant but rather painful. It is basically the difference between the market value of the asset used as collateral and the loan amount. For instance, you used a piece of land with a market value of $50,000 as collateral, but the bank gave you a loan of $40,000 on this. In this case, the difference of $10,000 (or 20%) is the haircut.
The amount of haircut largely depends on the lender’s perception of the risk related to the fall in the value of the asset. A general rule of thumb is lower the haircut, the safer the loan is, and vice versa. Also, a lower haircut allows for more leverage. The reduction (or the haircut) is expressed in the form of a percentage.
A haircut in finance is not only related to the loan. But, it is the reduction applied to the asset’s market value for calculating the margin, capital requirement, and collateral level.
Why are Haircuts Used?
Lenders need to make sure that the money they lend is paid back. The biggest assurance, of course, is an agreement with the borrower. But, if the borrower fails to repay, then the lender will have to sell the collateral. So, the lender needs to ensure that he is able to sell the collateral at a price enough to cover the loan.
However, the problem is that the value of the assets can go up and down. Also, lenders need some time to sell the assets, further leading to volatility. Therefore, a haircut provides a buffer against any loss in the value of the collateral.
For instance, a house could be worth $400 million now. But, there is no surety that its value will remain intact by the time the house is sold. The house could get damaged in a storm, or a new government policy could impact the value of the house. Therefore, lenders may go for about a 40% haircut in such a case.
Haircut in Stock Market
Haircut in the stock market means safeguarding the interest of the lender in the share market. As we have discussed above, the haircut in general, let us see an example to specifically understand the haircut in the stock market. Suppose Mr. A wants to borrow some amount by keeping his stocks as collateral. And he keeps stock worth $ 400 as collateral, but the lender only provides him with $280 as a loan. So, here we can see that there is a difference of $120 (30%) between the collateral worth and the loan provided. This is referred to as a Haircut in the stock market. Lenders use this because it might be possible that the value of the stock kept as collateral might fall on the other day, ultimately making him suffer a loss. Hence, to protect himself from the loss, he uses a haircut.
How are Haircuts Related to Loan-To-Value ratio?
A haircut in finance is also referred to as the complement of the loan-to-value ratio. When a haircut is added to the loan-to-value ratio, it totals 100%. For instance, you put an asset with a market value of $1 million as collateral. The bank applies a 30% haircut and approves a loan of $700,000. In this case, 70% is the loan-to-value ratio, and 30% is the haircut.
Factors Affecting Haircuts in Finance
A haircut is based on the level of risk associated with the loan. These risks include factors that may lead to a drop in the value of the collateral and also the default risk of the borrower. Some of the variables affecting the amount of haircuts are discussed below;
Lenders need to consider the risk they would face if they fail to sell the collateral for sufficient money after the borrower defaults. Fewer associated risks and greater accuracy in price predictability lead to less haircut. For instance, if a lender is confident about recovering the full loan on selling the collateral, then the haircut will be less.
For example, Treasury bills are commonly used as collateral for overnight borrowing between government securities dealers. Haircuts, in such cases, are negligible or very low due to the confidence in the value and credit quality of the collateral.
Vice versa, the securities that are known to suffer from high volatility and price uncertainty are subjected to higher haircuts. For instance, keeping equity as collateral may lead to a 50% haircut to a lack of price predictability. A 50% haircut is common for margin accounts, but it can be increased to a higher level if the security is more volatile and pose a higher liquidity risk. For instance, a haircut on leveraged exchange-traded funds, which are considered highly volatile, can rise up to 90%.
Further, the haircut also depends on how liquid the collateral is. If the collateral is highly liquid, then it is easy to sell it quickly. So, a smaller haircut is applied in this case. For assets that are harder to sell at fair market value, attract a higher haircut.
Another Meaning of Haircut
After the 2008 global financial crisis, the haircut in the finance world also meant getting less than what was owed. Like, “I owed $20,000 but only managed to get back $10,000. I got a 50% haircut.
Also, the term haircut is used when borrowing countries restructure debt by trimming repayments. Countries could enter into agreements to pay the loan with a 20% haircut. In certain situations, lenders could prefer partial repayment than the prospect of not being paid at all.