Journal of Economic Perspectives—Volume 25, Number 1—Winter 2011—Pages 29–48
A
nalysts of the recent nancial crisis often refer to the role of asset “re sales”
in depleting the balance sheets of nancial institutions and aggravating
the fragility of the nancial system. For example, a report from the U.S.
Treasury (2009) held: “An initial fundamental shock associated with the bursting
of the housing bubble and deteriorating economic conditions generated losses for
leveraged investors including banks. . . . The resulting need to reduce risk triggered
a wide-scale deleveraging in these markets and led to re sales.” Similarly, a discus-
sion of the crisis by leading American nancial economists (French et al., 2010,
p. 67) argued: “A bank that simply suffers large losses may be forced to reduce its
risk by selling assets at distressed or re-sale prices. If other banks must revalue their
assets at these temporarily low market values, the rst sale can set off a cascade of
re sales that inicts losses on many institutions. Thus, whether through defaults
or re sales, one troubled bank can damage many others, reducing the nancial
system’s capacity to bear risk and make loans.” Economists at the Federal Reserve
(Carlson, Haubrick, Cherney, and Wakeeld, 2009), in explaining the Fed policy
of guaranteeing money market funds during the crisis, write: “The effect of the
announcement was to permit an orderly management of withdrawals from the
money funds, preventing a liquidation of assets at distressed prices, which could
have destabilized the funds’ net asset values.”
Fire Sales in Finance and
Macroeconomics
■ Andrei Shleifer is Professor of Economics, Harvard University, Cambridge, Massachusetts.
Robert Vishny is Myron S. Scholes Distinguished Service Professor of Finance, University of
Chicago Booth School of Business, Chicago, Illinois. Their e-mail addresses are 〈ashleifer
doi=10.1257/jep.25.1.29
Andrei Shleifer and Robert Vishny
30 Journal of Economic Perspectives
The current crisis is not the rst where terminology of a “re sale” has been
used. In 1998 testimony to Congress following the collapse and rescue of the Long-
Term Capital Management hedge fund, Fed Chairman Greenspan testied (as
quoted in Caballero and Simsek, 2010): “Quickly unwinding a complicated port-
folio that contains exposure to all manner of risks, such as that of LTCM, in such
market conditions amounts to conducting a re sale. The prices received in a time
of stress do not reect longer run potential, adding to the losses incurred.”
The term “re sale” has been around since the nineteenth century to describe
rms selling smoke-damaged merchandise at cut-rate prices in the aftermath of a
re. But what are re sales in broad nancial markets with hundreds of participants?
How can re sales matter for generic goods, such as airplanes or nancial securities?
In modern nancial research, the term “re sale” has acquired a different meaning.
As we suggested in a 1992 paper, a re sale is essentially a forced sale of an asset at
a dislocated price. The asset sale is forced in the sense that the seller cannot pay
creditors without selling assets. The price is dislocated because the highest potential
bidders are typically involved in a similar activity as the seller, and are therefore
themselves indebted and cannot borrow more to buy the asset. Indeed, rather than
bidding for the asset, they might be selling similar assets themselves. Assets are then
bought by nonspecialists who, knowing that they have less expertise with the assets
in question, are only willing to buy at valuations that are much lower.
Assets sold in re sales can trade at prices far below value in best use, causing
severe losses to sellers. Of course, borrowers and lenders can seek to negotiate and
renegotiate contracts to avoid re sales, but sometimes they fail. Fire sales and efforts
to avoid them shed light on a range of empirical phenomena, such as the structure
of debt contracts, organization of bankruptcy regimes, and even the failures of arbi-
trage and market efciency in nancial markets. Fire sales can also lead to fragility
of nancial markets during crises. When a re sale leads to a sharp reduction in
an asset’s price, similar assets held by other market participants decline in value as
well, which might bring them also to nancial distress and forced asset sales. This
self-reinforcing process can lead to downward spirals or cascades in asset prices
and net worth of market participants. Because of re sales, risk becomes systemic.
Through this process, asset re sales and the deterioration of the net worth of rms
and nancial institutions can severely undermine nancial intermediation, leading
to reductions of real investment and output.
In this paper, we selectively review some of the research on re sales, empha-
sizing both concepts and supporting evidence. We begin by describing our 1992
model of re sales and the related ndings in empirical corporate nance. We
then show that models of re sales can account for several related phenomena
during the recent nancial crisis, including the contraction of the banking system
and the failures of arbitrage in nancial markets exemplied by historically
unprecedented differences in prices of very similar securities. We then link re
sales to macroeconomics by discussing how such dislocations of security prices
and the reduction in balance sheets of banks can reduce investment and output.
Andrei Shleifer and Robert Vishny 31
Finally, we consider how the concept of re sales can help us think about govern-
ment interventions in nancial markets, including the evidently successful Federal
Reserve interventions in 2009. Fire sales are surely not the whole story of the
nancial crisis, but they are a phenomenon that binds together many elements
of the crisis.
Modeling Fire Sales
A re sale of an asset is a forced sale, which can occur for a number of reasons. A
person might sell his car quickly because he has urgent medical expenses. A mutual
fund might sell securities because it faces capital withdrawals by its shareholders
(Coval and Stafford, 2007). A rm might quickly sell a division to pay a regula-
tory ne. However, the most common mechanism that precipitates forced sales of
both real and nancial assets is collateralized lending. In such lending agreements,
collateral is a borrower’s pledge of specic property to a lender to secure repayment
of a loan. If the borrower defaults on a loan, the borrower forfeits to the lender the
property pledged as collateral—sometimes automatically and sometimes through
a legal process. Most debt contracts, including mortgages and corporate debt, are
collateralized. When the borrower fails to either repay or meet some conditions
of the loan, the lender has the right to sell collateral, and might wish for various
reasons to do this quickly.
Despite the importance of collateralized lending in the world, the traditional
model of corporate nance of Modigliani and Miller (1958) has no role for collat-
eral in supporting debt contracts. In that model, debt is simply a promise of a part
of cash ows of the rm. Even second-generation corporate nance models empha-
sizing asymmetric information, such as Myers and Majluf (1984), leave no room
for collateral. These models thus fail to capture what can in situations of nancial
distress become the central feature of debt contracts.
Models of debt contracts supported by collateral began to appear in corporate
nance in the late 1980s, as the eld shifted its attention from describing securities
in terms of their cash ows to emphasizing their voting and other control rights
(Grossman and Hart, 1988; Aghion and Bolton, 1992; Hart, 1995). In an early paper
along these lines, Townsend (1979) models debt as a contract that gives the lender
the right to investigate the borrower and then seize its cash ows if the borrower
defaults on its debt. In this costly state verication model, control over the cash
ows shifts from the borrower to the lender after default. More natural models of
collateralized debt were proposed in the late 1980s by Hart and Moore (1994, 1995,
1998). In their models, the lender has the explicit legal right to seize and liquidate
collateral in the event of a default. The threat of liquidation provides an incentive
for the borrower to repay.
In these models, the liquidation value of collateral is taken as exogenous.
Although liquidation value can be low for a highly idiosyncratic asset with no
32 Journal of Economic Perspectives
alternative use (Williamson, 1988), there is no reason in these models why liquida-
tion value should be especially low for a generic asset such as a commercial airplane
or a nancial security. For such assets, the most plausible reason why specialists are
not buying is that they themselves are nancially constrained. This might happen,
for example, when all the industry specialists suffer the same adverse industry-wide
or market-wide shock and so are distressed and selling assets, at the same time. The
constraints facing industry specialists are the second essential feature of re sales.
An asset re sale is thus a forced sale in which high-valuation bidders are sidelined,
often due to debt overhang problems aficting many specialists simultaneously
(Shleifer and Vishny, 1992).
To describe this situation, we used a version of a model in Hart (1993) and
Hart and Moore (1995). An entrepreneur borrows some money from a lender to
buy an asset, such as an airplane, used to generate cash ows. The optimal contract
is a combination of short-term and long-term senior debt collateralized by the asset,
the former used to force liquidation when the project turns out to be bad, the latter
used to provide debt overhang that prevents the borrower from borrowing more
and wasting money. If the project is bad, the optimal contract calls for the sale of
the asset. Unlike Hart and Moore, we considered liquidation as a sale of the asset in
a market in which there is a potential high-valuation industry specialist who values
the asset a lot, but also low-valuation outsiders, who are not expert at using the asset
and hence have lower valuations. For example, if the asset is a plane, and the seller
is an airline, the high-valuation industry specialists would be other airlines. In this
case, low-valuation outsiders might be nancial buyers, who would buy planes to
lease them to other airlines.
The key observation is that the specialist industry buyer, who would be the natural
candidate for buying the assets, might itself be nancially encumbered, and hence
unable to bid, at precisely the time when the assets are being liquidated. This would
happen, for example, if liquidation is prompted by an industry-wide adverse shock. In
the case of airplanes, consider a decline in travel caused by higher perceived terrorism
risk, which creates cash shortages and external nancing problems for nearly all
airlines. If industry specialists do not have, and cannot raise, external funds to bid, the
asset in liquidation will need to be acquired by an industry outsider at a lower price
than value in best use. The specialists are sidelined. Financially constrained industry
buyers have become central to many models, and have been variously referred to as
specialists, natural buyers, optimists, and farmers, as we discuss below.
This analysis raises a number of questions. Why don’t the lender and the
borrower renegotiate, rather than have the lender repossess the asset? Why
doesn’t the lender, once it has repossessed the asset, hold on to it until market
conditions improve? Presumably, it is in everyone’s interest to avoid a re sale.
As we discuss below, substantial efforts are often made by market participants to
avoid re sales, by means of both how contracts are structured before the default
and nding new nancing rather than repossessing the asset after the default.
The Coase theorem is hard at work. But such solutions are not always possible.
Fire Sales in Finance and Macroeconomics 33
Borrowers often do not have the cash needed to avoid a re sale, and cannot raise
additional funds because (as in the Hart–Moore optimal nancial structure) they
face overhang from senior debt. When negotiations do not succeed because addi-
tional cash ows cannot be pledged and a high-valuation buyer is not available, a
re sale is difcult to avoid.
There are two related ideas in nance used to explain why some bidders do not
bid and hence the price falls below value in best use. Grossman and Miller (1988)
introduced the idea of slow-moving capital, arguing that sometimes it takes time
for capital to come to the market and in the meantime the price can deviate from
fundamental value. The authors had in mind a very short time period, perhaps a few
minutes or hours, during which price pressure from a rapid sale would be felt. This
theory is a less-compelling account of price dislocations that last for months. Allen
and Gale (1994) stress the costs of market participation as the explanation for the
absence of some buyers. Allen and Gale’s theory is a good explanation for why only
industry insiders, and not others, are present in the market at the time of the sale.
One still needs an explanation of why, in a re sale, it is these insiders, and especially
the insiders, who are sidelined.
Our model of re sales yields a notion of liquidity as the difference between
market price and value in best use. When market participants are nancially unen-
cumbered, liquidation brings prices close to value in best use, and markets are said
to be liquid. When, in contrast, market participants—and in particular specialists in
using or holding the asset—are nancially encumbered, liquidation leads to sale of
assets to outsiders at lower prices, and markets are said to be illiquid.
Evidence on Fire Sales of Real Assets
The theory of re sales raises questions. Do re sales actually exist? Do they
have signicant effects on prices? Do rms take actions to avoid them? Do the terms
of collateralized loan contracts reect the risk of re sales? Are bankruptcy regimes
responsive to the risk of re sales?
The empirical research on re sales of real assets began with Pulvino’s (1998)
study of prices of used airplanes. Commercial airplanes present a great advan-
tage for the study of asset sales because the industry is heavily regulated, and as
a consequence, an enormous amount is known about each airplane, so that it
becomes possible to control for quality. Pulvino compared the prices of planes
sold by nancially distressed airlines to those sold by the airlines that were not
distressed, holding the exact characteristics of the planes constant. He found that
used planes sold by distressed airlines bring 10 to 20 percent lower prices than
planes sold by undistressed airlines. Similar magnitudes appear in other studies.
For example, Campbell, Giglio, and Pathak (forthcoming) report in a study of
forced home sales that “foreclosure discounts are on average 27% of the value of
the house.”
34 Journal of Economic Perspectives
Other research shows that rms try to avoid such sales of assets in illiquid
markets. Asquith, Gertner, and Scharfstein (1994) nd that, when industry condi-
tions are bad, a debt work-out is more likely than a liquidation. Schligemann,
Stulz, and Walkling (2002) study divestitures of business units by U.S. rms, and
nd that rms are more likely to divest segments from industries with a more
liquid market for corporate assets, even when this means keeping some of their
worst-performing units. Almeida, Campello, and Heckbarth (2009) show how
poorly performing rms agree to be acquired by rms with substantial liquidity,
even when there are no synergies in the merger, in order to avoid having to sell
assets in illiquid markets. These are clear efforts by rms and their lenders to
avoid joint wealth loss in a re sale.
What about contractual adaptations to the risk of re sales? Benmelech and
Bergman (2008) take advantage of the fact that, in the United States, the acquisition
of airplanes by airlines is often nanced by individual plane debt contracts. They
then consider what happens during renegotiation of debt contracts collateralized
by airplanes. They nd that airlines successfully renegotiate their lease obligations
downward when their nancial position is sufciently poor and when the liquida-
tion value of their eet is low. What determines an airline’s bargaining power is
the ability of the lessors to lease the plane to its competitors, which falls when the
industry is in distress. Benmelech and Bergman (2009) nd that airlines borrow
on more attractive terms when airplanes used as collateral have less nancially
encumbered buyers. Benmelech and Bergman (forthcoming) show quite remark-
ably that the bankruptcy of an airline raises the cost of capital to its competitors
who have similar airplanes. Using a broader sample of industries, Ortiz-Molina and
Phillips (2010) also nd that rms in industries with more liquid assets (meaning
more potential buyers), and during periods of high asset liquidity, face a lower cost
of capital. This evidence suggests that lenders to rms are aware of the costs of re
sales and structure debt contracts to take them into account.
Fire sale considerations also play a role in the debate on the optimality of
the two main choices in corporate bankruptcy: reorganization (Chapter 11 of the
U.S. Bankruptcy Code) or liquidation (Chapter 7). Many economists and legal
scholars favor Chapter 7 liquidation, using the argument that auctions generally
allocate resources to those who value them most (for example, Baird, 1986). In our
1992 paper, we argued that this logic does not hold when high-valuation bidders
in auctions are nancially impaired. Indeed, the standard case for Chapter 11
reorganization, while not focusing specically on re sales, warns about the risk
of lost value arising through piecemeal liquidation of rms for prices substantially
below the value in best use. In countries that rely on Chapter 7–style liquidations,
such as Sweden, the original lenders to rms nance the liquidation bids, often by
the existing management, thus avoiding re sales (Stromberg, 2000). Subsequent
research on a cross-section of countries has conrmed that liquidation can be very
costly. In developed countries, in particular, liquidation leads to lower recovery rates
for creditors than reorganization (Djankov, Hart, McLiesh, and Shleifer, 2008).
Andrei Shleifer and Robert Vishny 35
The punch line of corporate nance research is that re sales of real assets do
exist, that they lead to substantial price discounts, and that rms and lenders are
aware of these discounts and take them into account both before and after the onset
of nancial distress. But there is limited drama in re sales of real assets because
rms, unlike nancial institutions, do not exacerbate crises when they sell assets in
re sales. Fire sales of nancial assets raise new challenges.
Fire Sales of Financial Assets
Fire sales of securities have broader effects than re sales of real assets because
nancial investors, such as hedge funds or banks, nance themselves with money
that can be withdrawn quickly. Demand deposits in banks are the standard example,
but investors in mutual funds and hedge funds can also withdraw funds on short
notice. Financial institutions are also typically heavily leveraged, and some of their
loans are short-term, collateralized, or both. Many banks fund their activities with
commercial paper, which is a debt instrument with duration between a day and
several months. Such funding requires almost continuous renewal. More recently,
hedge funds and dealer banks nanced some of their activities with repurchase
agreements, which are extremely short-term loans collateralized by longer-term
securities. Adrian and Shin (2010) document high and growing leverage ratios of
nancial institutions, reaching debt-to-equity ratios of 30 or more for dealer banks.
Much of this debt is short-term collateralized loans.
The extreme vulnerability of nancial investors to sudden stops in short-
term nancing can lead to cascades of liquidation. When nancial investors are
forced to liquidate their holdings, security prices decline. These declines, in
turn, prompt further fund withdrawals and collateral calls for both these inves-
tors and their competitors. Such self-reinforcing re sales were central in the
recent nancial crisis. We begin by describing the relevant mechanisms, and then
turn to crisis facts.
In nancial economics, the discussion of re sales of nancial assets is intimately
related to an older idea of limited arbitrage, which is the central building block of
models of market inefciency and behavioral nance (Shleifer and Summers, 1990).
In the standard view of arbitrage, arbitrageurs lean against the wind to correct the
mispricing of nancial assets—and thus their inuence is fundamentally stabilizing.
But might it be possible that arbitrageurs lose funds under management, and hence
their ability to lean against the wind, at precisely the same time as prices move away
from fundamental values and arbitrage opportunities improve? Might arbitrageurs
be more likely to exit their positions, rather than doubling up, when prices are most
wrong? Might they sell assets in a re sale?
In Shleifer and Vishny (1997), we connected the ideas of limited arbitrage and
re sales in a model of arbitrageurs, such as hedge funds, who experience capital
withdrawals when their performance is poor. Consider an arbitrageur who raises
36 Journal of Economic Perspectives
funds from outside investors and bets against a mispricing of a security which the
arbitrageur knows for certain will disappear after some time. Suppose, however, that
this mispricing temporarily gets more extreme, and so the arbitrageur loses money.
Unfortunately for this arbitrageur, outside investors do not know whether the losses
on these positions are due to a temporary deepening of mispricing, or rather to the
errors in this arbitrageur’s strategies. Absent such knowledge, the outside investors
may choose to withdraw capital. If they do so, the arbitrageur who is fully invested
has to reduce its position and return capital to investors, even though holding on,
or even adding to the holdings, is extremely attractive.
But here comes the problem. It is likely that the arbitrageur is not unique in
following a particular strategy. When this arbitrageur and a number of the arbitra-
geur’s competitors who are doing the same thing all face fund withdrawals, they
all start liquidating their positions, which only causes mispricing to widen further.
This is a re sale of nancial assets, but with an even deeper problem: As arbitra-
geurs liquidate their positions and mispricing widens, their losses grow, so that re
sales and the withdrawals of funds from arbitrage are self-reinforcing. This feed-
back effect from growing mispricing to arbitrageur losses causes prices to spiral or
cascade away from fundamental values. This process can lead to a complete collapse
of the market, or it can be arrested by the entrance of outsiders to support the
market when prices fall far enough.
Our 1997 model focused on the withdrawals of investor funds, but a similar and
even stronger argument can be made if arbitrageurs nance their positions with
debt. In an important paper, Kiyotaki and Moore (1997) develop a macroeconomic
model of credit cycles driven by self-reinforcing changes in asset values and avail-
ability of collateralized loans. In their model, there is a homogeneous asset called
“land.” They refer to high-valuation users of land as “farmers,” and to low-valuation
users as “gatherers.” Because farmers are the high-productivity users of land, they
borrow as much as they can to invest, using their land holdings as collateral. But
suppose that an adverse shock hits farmers’ prots. Now their net worth is not as
high, and they cannot maintain as high a level of borrowing. Because the farmers
are levered up to the maximum, they have to liquidate some land. But all the other
farmers are also fully levered up, so the land must be sold to the less-productive
gatherers who have some spare debt capacity but value the land less. A re sale
occurs. As land shifts to less-productive gatherers, its fundamental value declines,
which reduces its market value as collateral and precipitates further deleveraging
and re sales of land by farmers. The process only stops because gatherers face
decreasing marginal productivity, so eventually land becomes so unproductive in
their hands and cheap that farmers can afford to hold it. In this way, Kiyotaki and
Moore obtain a feedback from the declining value of collateral to further delever-
aging by high-valuation users, which results in a downward spiral in prices.
Gromb and Vayanos (2002) present a related model of re sales leading to
widening mispricing in the context of nancial arbitrage. In their model, a widening
of mispricing can lead to forced deleveraging by arbitrageurs due to a decline of
Fire Sales in Finance and Macroeconomics 37
collateral values, which in turns leads to further widening of mispricing. Equity and
credit withdrawals by nanciers from arbitrageurs work in the same direction of
causing a downward price spiral in the valuation of a mispriced asset.
The workings of our 1997 model and the Gromb–Vayanos (2002) model were
seen in the collapse of Long Term Capital Management (LTCM) in 1998 (referred
to in the Greenspan testimony mentioned at the start of this paper). LTCM was
a heavily leveraged hedge fund that sustained some losses on its positions during
the Russian government’s bond default in summer 1998. These losses precipitated
substantial calls for cash or more collateral by short-term lenders to LTCM, as well
as fund withdrawals by its investors. Unable to come up with cash, LTCM had to
liquidate its positions in a re sale, which caused enormous price dislocations and
losses for other hedge funds, which then also had to liquidate. The process was
stopped before it could run its full destructive course by a takeover of LTCM by a
consortium of nancial institutions organized by the New York Federal Reserve to
“avoid a re sale liquidation of LTCM’s positions” (Edwards, 1999).
An important feature of debt contracts collateralized by securities is time-varying
margins often called “haircuts.” To protect themselves from default, lenders require
borrowers to post a margin, which means that they lend less than 100 percent of the
price of the collateral. If the market price of collateral falls, lenders require either
more collateral or some cash back, which the borrower has to come up with to avoid
having the collateral liquidated by the lender. This mechanism can precipitate a re
sale in two distinct ways. First, as the value of collateral declines, the borrower might
be unable to come up with the cash to maintain its loan, and hence the collateral
will be liquidated. Second, the margins or haircuts are determined endogenously
(Geanakoplos, 2003). A negative shock to collateral can lead to increased price vola-
tility (or alternatively increased disagreement among investors), and thus increased
equilibrium margins and haircuts imposed by lenders keen to protect themselves
against losses. If that happens, the borrower must come up with still more collateral,
or return some cash. This is again extremely destabilizing, since increases in margins
force traders to reduce their positions, which can in turn further deepen mispricing.
Several of the mechanisms just described are analyzed together by Brunner-
meier and Pedersen (2009), who model the simultaneous determination of security
prices and margins. In their model, as security prices fall, margins or haircuts
required to borrow using these assets as collateral rise because by assumption vola-
tility increases. They refer to this phenomenon as a decline in “funding liquidity.”
Unable to meet margin calls, arbitrageurs are forced to sell their securities in a re
sale, making markets illiquid in the sense of prices diverging from values. They
refer to this as “market liquidity,” similar to the sense of our 1992 paper. The two
spirals described by Brunnermeier and Pedersen reinforce each other: as prices fall,
margins rise, arbitrageurs sell, and prices fall further, leading to a collapse of both
prices and liquidity in a market.
Even before the nancial crisis, considerable empirical work documented the
signicance of limited arbitrage as related to re sales in permitting deviations of
38 Journal of Economic Perspectives
prices from fundamental values. We describe two strands of this research. The rst
concerns failures of arbitrage directly. Mitchell, Pedersen, and Pulvino (2007), for
example, study merger arbitrage during the crash of 1987 and convertible bond arbi-
trage in 2005, a time when the convertible bond market imploded following investor
withdrawal of equity capital from money-losing hedge funds. They show quite directly
the self-reinforcing effects of arbitrageur losses, equity withdrawals, and liquidation of
positions, which in turn lead to further losses. Mitchell and Pulvino (2010) present
an even more striking study of arbitrage failures during the current nancial crisis.
The authors look at a range of very common arbitrage strategies involving corporate
securities, such as convertible debt arbitrage, credit default swap–corporate debt arbi-
trage, and several others. They show that in the worst months of the crisis during 2008,
arbitrage spreads—differences in the prices of nearly identical securities—reached
fantastic levels. For example, convertible debentures normally included in arbitrage
trades, and typically mispriced by less than 2 percent, sold at a 10 percent discount.
A second line of research, initiated by Coval and Stafford (2007), focuses on
the behavior of mutual funds. These funds are forced to sell securities immediately
in response to withdrawals by their investors. Coval and Stafford point out that by
focusing on portfolios of stocks that mutual funds hold at the beginning of the
quarter, and knowing their returns during the quarter (since mutual funds report
net asset values continuously), one can predict roughly which stocks will be sold
when investors liquidate their holdings of poorly performing funds at the end of
the quarter. This approach turns out to successfully predict future negative returns
on the stocks held by poorly performing funds, and has been used in other studies
(Dong, 2010; Ellul, Jotikasthira, and Lundblad, 2010; Greenwood and Thesmar,
2009; Jotikasthira, Lundblad, and Ramodarai, 2010).
Fire Sales and the Financial Crisis
To illuminate the signicance of re sales in the recent nancial crisis, we start
with a generally accepted narrative of the crisis, as summarized in Table 1. We sketch
only the most basic outline; more detailed accounts are contained in Brunnermeier
(2009), Gorton and Metrick (2010), and Pozsar, Adrian, Ashcraft, and Boesky
(2010). The nancial crisis was most proximately related to the bubble in the
housing market and to the nancing of this bubble with mortgage-backed securi-
ties. These mortgage-backed securities were created by pooling together portfolios
of mortgages and then separating them into tranches such that the most senior
tranches were perceived to be virtually safe and rated AAA by credit rating agencies
(Coval, Jurek, and Stafford, 2009). Because of this high rating, senior tranches of
mortgage-backed securities ended up in the portfolios of institutional investors such
as pension funds and insurance companies, but also as highly leveraged investments
on the balance sheets of hedge funds, dealer banks, commercial banks, and special
investment vehicles guaranteed by these banks.
Andrei Shleifer and Robert Vishny 39
There remains a controversy as to why dealer banks were so exposed to
mortgage-backed securities. Some of their holdings were surely explained by
inventory and other market-making considerations, but some banks were perhaps
speculating on the spreads between returns on mortgage-backed securities and the
cost of funding these positions with commercial paper and repurchase agreements
(Acharya, Schnabl, and Suarez, 2010; Gorton and Metrick, 2010). It also seems
likely that many market participants, including the rating agencies themselves, did
not understand the risks of mortgage-backed securities (Jarrow, Li, Mesler, and van
Deventer, 2007; Coval, Jurek, and Stafford, 2009; Gennaioli, Shleifer, and Vishny,
forthcoming). Whatever the true reasons for investor condence in mortgage-
backed securities, the result was that the high-valuation buyers of mortgage-backed
securities (and similar asset-backed securities), such as hedge funds and nancial
institutions, nanced some of their holdings with collateralized short-term debt.
As the grim news about the housing market and the safety of AAA-rated securi-
ties started to unfurl in 2007, investors in AAA-rated mortgage-backed securities,
like many others, were caught by surprise. Some of the short-term funding arrange-
ments, such as asset-backed commercial paper, evaporated. The Federal Reserve
Table 1
A Narrative of the Financial Crisis
1. A housing bubble inates in the mid 2000s. Homes are nanced by mortgages that are increas-
ingly securitized. Although the quality of mortgages deteriorates, the securities into which these
mortgages are packaged are perceived to be safe and receive AAA-ratings.
2. Financial institutions such as banks and dealer banks retain substantial exposure to the real estate
market through direct holdings of commercial real estate and direct holdings of mortgage-backed
securities, but also through implicit guarantees of special investment vehicles they organize that
hold mortgage-backed securities and nance them with commercial paper.
3. Bad news about the housing market in the summer of 2007 surprises investors in AAA-rated mort-
gage-backed securities and precipitates a sequence of substantial disruptions in nancial markets,
such as the collapse of the asset-backed commercial paper market. Aggressive liquidity interven-
tions from the Federal Reserve, including lending to market participants against risky collateral,
stabilize markets through the summer of 2008 despite continued bad news about housing.
4. In September 2008, several events, including a run on money market funds, nationalization of
AIG, Fannie Mae, and Freddie Mac, and particularly the collapse of Lehman Brothers, precipitate
a massive nancial crisis. Banks’ balance sheets contract because of massive losses on assets and
withdrawal of short-term nancing, which prompts banks to liquidate assets in re sales. The con-
sequences of re sales are exacerbated by uncertainty about bank solvency and government policy.
5. In response to their losses and to reduced availability of nancing, banks cut lending to rms.
6. The economy slides into a major recession.
7. Starting in October 2008, the government begins massive interventions in nancial markets,
including equity injections in banks, expansion of lending against risky collateral, but also direct
purchases of long-term agency bonds, which sharply reduce the supply of risky bonds in the mar-
ket. The combination of government interventions eventually stabilizes the nancial markets by
spring 2009, although the real economy remains sluggish.
40 Journal of Economic Perspectives
intervened starting in the summer of 2007 by facilitating mergers of troubled
nancial institutions and lending to others against risky collateral. This series of
interventions successfully delayed a major crisis by over a year.
In September 2008, however, as bad news about the housing market and the
values of mortgage-backed securities continued to pour in, markets collapsed. The
immediate impetus for the collapse was some combination of the run on money
market funds investing in the commercial paper of banks, virtual nationalization of
the AIG insurance company as well of government-sponsored housing enterprises
Fannie Mae and Freddie Mac, and most importantly the bankruptcy of Lehman
Brothers investment bank. As these events rolled out in quick succession, many
forms of short-term nancing, such as commercial paper and repurchase agree-
ments, dried up, forcing banks to shrink their balance sheets. Banks also had to
improve the quality of their assets for regulatory purposes, forcing them out of
previously safe but now risky securities. To accomplish this, banks sold assets in a
market where other banks and nancial institutions were themselves liquidating
their holdings, resulting in massive price declines and dislocations (Adrian and
Shin, 2010). We saw a classic cycle of price collapses and deleveraging described by
re sales models, driven by both capital withdrawals because of declining collateral
values and growing haircuts because of increased risk.
In fall 2008, the price of risk rose to unprecedented levels, and nancial
markets plummeted. But why were the events after September 2008 so much worse
than those before? After all, bad news about housing and AAA-rated mortgage-
backed securities started arriving in the summer of 2007, and dramatic events, such
as the drying up of the asset-backed commercial paper market, started then. In our
view, after the Lehman bankruptcy, a much larger proportion of specialist inves-
tors were sidelined from bidding for securities than in 2007 or early 2008. Banks
sustained massive losses and could not easily borrow to buy assets. The contrac-
tion of commercial paper and repo markets eliminated short-term funding that
nanced the holdings of dealer banks (Adrian and Shin, 2010; Gorton and Metrick,
2010). Hedge funds as well sustained major losses and, if anything, were liquidating
their holdings because of investor redemptions and withdrawal of prime broker
nancing. Before the Lehman bankruptcy, in contrast, liquidity provision by the
Federal Reserve kept most of the specialist buyers in the market. With natural buyers
of distressed securities sidelined after Lehman, security prices went into a free fall.
The Federal Reserve began to intervene in markets almost immediately after
Lehman, injecting equity into commercial banks, expanding lending to nancial
institutions against risky collateral, guaranteeing the commercial paper markets,
and eventually buying hundreds of billions of dollars of risky securities, mostly
bonds of Fannie Mae and Freddie Mac. Essentially, the Federal Reserve became
the high-valuation holder of risky securities. Between accepting risky collateral as
a guarantee for loans on advantageous terms, and removing massive quantities of
securities from the market, the Federal Reserve stabilized banks and the nancial
system by spring 2009. The price of risk fell. The economy remained sluggish, but
Fire Sales in Finance and Macroeconomics 41
a depression was avoided. Importantly, the fundamentals of the economy were
probably worse in spring 2009 than earlier; the fact that nancial markets stabilized
quickly suggests that liquidity problems caused by re sales were indeed severe after
Lehman, and had to be addressed through public interventions. The nancial crisis
appears to have been a liquidity crisis, not just a solvency crisis.
The re-sales mechanism unies several aspects of the propagation of the
crisis. It explains how hedge funds, dealer banks, and commercial banks suffered
huge nancial losses, largely from reductions in the value of their security hold-
ings. It sheds light on massive violations of arbitrage conditions as hedge funds lost
their nancing (Mitchell and Pulvino, 2010; Krishnamurthy, 2010; Garleanu and
Pedersen, 2010). And it explains why investors most reliant on short-term nancing
were particularly exposed, and pulled back the most. The common theme in all
these phenomena is the sidelining of natural buyers of distressed securities, contrib-
uting to the near-shutdown of key parts of the nancial system.
Fire Sales in Macroeconomic Models
How did re sales and deterioration of balance sheets of banks lead to a
broader economic crisis? How did government policy stabilize the market? In this
section and the next, we argue that the re-sales perspective can shed light on these
questions as well.
The idea that asset liquidations can have adverse consequences for real activity
has been present in the macroeconomics literature at least since the 1930s. In his
debt deation theory, Fisher (1933) argues that an adverse shock to the value of
corporate assets forces rms to sell those assets to meet their debt obligation, and
that such asset sales lead to declines in output prices. The resulting deation raises
the real value of debt denominated in nominal terms and forces further liquida-
tions, leading to a vicious debt deation cycle. Although the theory is not entirely
transparent, Fisher offers some impressive data consistent with the story.
For a more modern analysis, we need to explain why re sales of nancial
assets such as bonds would entail real consequences. Why would pecuniary effects
from mispricing not only transfer wealth from sellers to buyers of securities but also
undermine physical capital investment? The nancial crisis saw the decline of bank
lending to rms and of real investment (Ivashina and Scharfstein, 2010; Campello,
Graham, and Harvey; 2010, Kahle and Stulz, 2010). What can explain it?
Bernanke and Gertler (1989) argued that shocks to corporate net worth reduce
the ability of rms to post collateral and borrow, and as such undermine corporate
real investment. The Kiyotaki and Moore (1997) paper, in addition to modeling
price spirals due to deleveraging and re sales of land by farms, shows that, as land
values decline, so does the net worth of farms and their investment. In the crisis, a
sharp decline in asset values was inevitable as the housing bubble burst, but re sales
have worsened these declines.
42 Journal of Economic Perspectives
Most attention in the analysis of the crisis has however focused on the declines
in balance sheets of banks. Such declines would reduce bank-nanced investment
through the so-called bank lending channel (Bernanke and Blinder, 1988). As a
bank’s net worth declines, so does its ability to extend credit. Research establishing
the importance of the lending channel is voluminous; Kashyap and Stein’s (2000)
is among the most convincing papers. Stein (2010) explains how the bank lending
channel can account for investment reductions during the crisis.
There are two additional ideas about how re sales of securities and the reduc-
tions in the net worth of banks can undermine investment. Price dislocations
resulting from re sales inuence bank decisions about whether to lend to real
investment projects, to hold cash, or to pursue other nancial investments. Fire
sales may increase the attractiveness of the alternatives to nancing real investment.
One key alternative is for a bank to hold cash and “keep its powder dry” because
it might need cash in the future. The idea that banks might want to hoard liquidity has
been around for awhile, going back to Keynes’ description of “liquidity preference”
as an alternative to real investment. In the context of asset re sales, in Shleifer and
Vishny (1997), we discuss “the hold back effect,” whereby nancial investors might
hoard cash if the possibility of deepening mispricing and improving arbitrage oppor-
tunities seems likely. Holmstrom and Tirole (1998) describe liquidity hoarding as a
precaution rms or banks use against future liquidity needs. Caballero and Simsek
(2010) present an argument for cash hoarding when banks face uncertainty about
the solvency of other banks they are dealing with. Several recent papers have looked
at these issues in re-sales models, emphasizing macroeconomic consequences of
cash hoarding (Acharya, Shin, and Yorulmazer, forthcoming; Brunnermeier and
Sannikov, 2010; Diamond and Rajan, 2010). Consistent with these studies, there
is compelling evidence that banks sharply increased their holdings of cash and
deposits with the Federal Reserve in 2009, presumably at the expense of lending
(He, Kang, and Krishanmurthy, 2010).
In Shleifer and Vishny (2010a), we alternatively argue that real investment
must compete with investment in nancial assets when bank capital is scarce. We
start with the observation that re sales of assets by deleveraging nancial institu-
tions, such as banks, drive the prices of those assets below fundamental values. If
price dislocation is extreme enough, banks will choose to invest in underpriced
assets rather than lend money to rms, and real investment will suffer. The evidence
presented by He, Kang, and Krishnamurthy (2010) and Ivashina and Scharfstein
(2010) is consistent with the prediction that banks have used spare balance sheet
capacity, including capital injections from the government, to buy securities rather
than to lend in the wake of the nancial crisis.
The mechanisms we have described focus on the social costs of re sales after
they have occurred. But presumably if market participants consider the possibility of
re sales before they arise, the conditions of borrowing and lending should reect
the risks of re sales. In this situation, there might be no social losses from pecuniary
externalities and no over-borrowing relative to the social optimum. Several studies
Andrei Shleifer and Robert Vishny 43
have, however, argued that this is not so. Lorenzoni (2008) shows that when rms
ignore the effect of re sales on other rms, the level of borrowing need not be
socially efcient. Stein (2010) begins with the crucial observation that, prior to the
crisis, many of the securitized mortgages were essentially transformed by nancial
intermediaries into shorter-term securities, such as commercial paper, that were
subsequently sold to investors. In his model, this demand from money market funds
for safe short-term assets drove the securitization process and made it protable.
Stein then shows that, because the consequences of re sales of securities are not
fully internalized by banks, the creation of short-term assets was excessive from the
social point of view.
An alternative approach to explaining why leverage is socially excessive is to
drop the assumption of rational expectations. In Shleifer and Vishny (2010a), we
focus on investor optimism in the securitized loan market as a precursor of a crisis. As
banks make and securitize loans to cater to investor demand, the incentives of even
fully rational banks lead to overexpansion of lending and excessive leverage in good
times, but then re sales and credit crunches in bad times. Such credit crunches
create real efciency losses when good investment projects are not nanced.
In Gennaioli, Shleifer, and Vishny (forthcoming), we also dispense with rational
expectations, but argue alternatively that during the period of growing home prices
and securitization, market participants neglected the risk that home prices could
collapse, leading to defaults even on AAA-rated securities. We show that this neglect of
small risks could have led to the massive assumption of such risks by risk-averse inves-
tors, who then ed to safety when they became aware of the risks they were bearing.
The punch line of this analysis is that the sidelining of natural buyers in re
sales can lead to declines in asset prices and the net worth of nancial institutions,
which in turn trigger cuts in lending. Fear of future re sales likewise encourages
nancial institutions to hoard cash rather than nance investment. The re-sales
mechanism thus entails real, and not just nancial, consequences.
Policy Implications
Economic theory suggests that re sales entail systemic risk and signicant
externalities. Well-designed government policies aimed at limiting res sales can
therefore improve welfare.
Some policies aim to reduce the chances of a re-sale scenario arising. Exam-
ples of such policies include increases in the capital cushions of nancial rms and
improvements in the plumbing of the nancial system (French et al., 2010; Hanson,
Kashyap, and Stein, in this issue). Likewise, policies such as mandating higher hair-
cuts and margins in derivative markets aim to stop the cycle of deleveraging and re
sales before it starts.
Here, we focus on policies that seek to contain and limit the effects of re sales
that are already underway. When the government reacts to a re sale in progress,
44 Journal of Economic Perspectives
what should it be seeking to accomplish, and what type of intervention is most likely
to be benecial? During re sales, many key nancial institutions such as banks are
sidelined due to their inability to access capital. In this setting, two distinct ways to
increase bank lending and real investment have been proposed: 1) the government
can lend to banks against risky collateral; 2) the government can purchase assets
directly or provide subsidies targeted at the purchasers of certain assets.
The relative merits of these two types of interventions have been addressed,
albeit briey, in the recent literature. Diamond and Rajan (2010) support liquidity
injections into the banking system over government asset purchases on the grounds
that the government is not able to judge whether asset prices are truly dislocated.
Conversely, they argue that misguided government purchases could distort asset
prices in other directions and even result in losses. On the other side, in Shleifer
and Vishny (2010b), we argue that liquidity injections into the banking system
may not increase asset prices or lead to new lending to rms. Instead, banks may
engage in precautionary hoarding of liquidity or may purchase assets but still leave
their prices well below the level at which new lending becomes attractive. A further
problem with providing loans or equity to banks is that the government may end
up supporting institutions that ultimately fail and perhaps encourage some of the
desperate intermediaries to gamble with government funds by taking on more
risk. Security purchases can address asset price dislocations directly, without
providing extra subsidies to weak or irresponsible banks. To avoid overpaying for
assets, government purchases could target potentially less-toxic asset classes, with
greater prospects of reviving new lending in the short run and a lower chance of
government losses.
The idea of the government buying nancial assets may seem suspicious to a
number of economists. After all, most economists would not think of the govern-
ment buying airplanes, even during a re sale. But buying nancial assets during
a re-sale crisis is very different from buying airplanes. First, nancial markets
have more systemic implications for the rest of the economy than markets for used
airplanes. Restoring the balance sheets of banks would unlock the lending channel
in a way that restoring the balance sheets of airlines would not. Second, the govern-
ment would be a terrible owner of airplanes, unable to negotiate leases nearly as
efciently as the private sector. In contrast, the Federal Reserve might be a reason-
ably efcient owner of certain xed-income securities, especially if it can mostly
avoid buying “lemons” by purchasing the relatively safe ones.
How does the Federal Reserve know that some securities are cheap, rather than
reecting a high risk of insolvency of underlying issuers? Of course, it can never
know for sure, but in the aftermath of the Lehman bankruptcy in September 2008,
there were many striking indications that illiquidity was a problem. For example,
10-year government agency bonds that the Fed ended up buying were yielding up
to 170 basis points more than similar duration Treasury bonds. This compares to
a normal spread on agency paper of 10 to 30 basis points. In many other markets,
wide credit spreads for the highest quality borrowers pointed to illiquidity rather
Fire Sales in Finance and Macroeconomics 45
than fundamental problems. Even setting credit spreads aside, the Federal Reserve
witnessed the near implosions of commercial paper and repo markets, effectively
sidelining natural buyers who relied on these markets to nance purchases of
risky debt. This too seems to point to re sales and illiquidity rather than pure
solvency problems.
U.S. government policies in response to the nancial crisis and to re sales in
particular took various forms. The government bailed out some nancial institu-
tions, but also lent money against risky collateral and bought some assets. Prior
to the Lehman bankruptcy in September 2008, liquidity provision to nancial
institutions was the dominant strategy; in 2009, purchases of agency debt became
important. We do not know which one of these strategies was ultimately effective in
arresting the crisis in spring 2009, although it does appear that pure liquidity injec-
tions and rescues of institutions in 2008 were insufcient to stop the slide. Federal
Reserve Chairman Bernanke (2009) described the Fed policy of credit easing in
winter 2009, and his justications seem to largely correspond to the analysis of
re sales presented here. In Shleifer and Vishny (2010b), we describe the virtuous
circle and the multipliers that arise from government security purchases as market
liquidity improves.
What emerges most clearly from the re-sales models is the complementarity
between tough preventive policies to reduce the risk of re sales and soft policies
when a re sale and nancial crisis is underway. The basic prescription is for the
government to intervene in markets to stop re sales quickly, because failure to do
so can severely harm the nancial system and the economy as a whole. Although the
choice is a controversial one, we think there is a case for the government supporting
purchases of dislocated securities by market participants, or even buying them
directly, rather than supporting weak or poorly run nancial institutions. But this
type of softness in the face of an actual crisis should be combined with safeguards
that minimize the chance that the banking system becomes engulfed in re sales.
■ We thank Efraim Benmelech, Eduardo Davila, Nicola Gennaioli, Robin Greenwood, Samuel
Hanson, Oliver Hart, Anil Kashyap, Joshua Schwartzstein, Alp Simsek, Jeremy Stein, René
Stulz, and the editors for helpful comments.
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