What is... | February 10, 2012

What is a haircut in financial markets?

In financial markets, haircuts are painful rather than pleasant. But like a visit to the regular hairdresser or barber, they can leave a hole in your finances.

Painful haircuts
Government debt problems in Greece, Ireland, Spain and other parts of the Eurozone have put financial market haircuts firmly in the headlines since 2011. Haircuts can be used when countries (and other borrowers) restructure debt - trimming repayments. Agreements might allow repayment part of the original loan, with 20% haircut, for example, seeing 80c repaid for every €1 borrowed. Partial repayment might seem better to the lender than the prospect of not being paid back at all, particularly if it is a small trim rather than a more radical “restyling”.

Like the results of visiting an overzealous stylist, the more severe the cut, the longer it tends to take to “grow out” and be forgotten.

Two styles of haircuts
In financial markets, the term haircut can be used in two ways.

The first, as outlined above, refers to a cut in the value of financial assets used to support a loan. If, for example, a company or institution struggles to repay a loan, the providers of the loan may agree to “take a haircut” by reducing the amount they are repaid (rather than risking not being repaid at all). In this case, haircuts are meant to provide a one-off adjustment to allow both the lender and the borrower to move on after a period of financial pain.

The second refers to the difference between the buying and the selling price of a share, bond or other financial instrument. The difference is often a handling fee for the transaction.

The term sounds simple, however only 20% in an eZonomics poll knew what a financial market haircut was – suggesting it is not widely understood. Its use is still relatively new. Economics author Olaf Storbeck blogs that the term first appeared in the American Economic Review in 1989.

Styles since 1970
How big are haircuts? The first complete database of investor losses in all restructurings with foreign banks and bondholders from 1970 until 2010 was released in the research paper Sovereign Defaults: The Price of Haircuts. It covered 180 cases in 68 countries and found the average sovereign haircut was 37% but there was large variation and “average haircuts have increased over the last decades”.

Are bonds a safe investment?
Government defaults are relatively rare but such haircuts serve as a reminder of financial risks in investing. Even government bonds, widely considered to be at the safer end of the risk spectrum, can lead to losses. For more on the risk profiles of corporate and government bonds, watch the eZonomics videos on How bonds work and on basic investment products.


eZonomics team
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