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What is it?

Haircut is a term that's usually applied to calculations made by the world's central banks. Specifically, it's the percentage difference between the market value of assets that financial institutions swap for cash at the discount window and the value the central bank allocates to those assets.

For example, a lending bank might swap a Treasury bill worth $100 for cash at the Federal Reserve's discount window. If the Fed only pays out cash worth $90, the haircut would be 10%.

What's it got to do with the financial crisis?

Under the credit crunch, central banks have been forced to swap an increasingly wide range of assets either for cash, or for government bonds that can be exchanged for cash, in order to pump liquidity back into the banking system.

With banks like the European Central Bank and the Bank of England now accepting risky assets like asset backed securities linked to mortgages, haircuts have been increasing. The riskier the collateral, the larger the haircut is. The Bank of England, for example, charges a 12% haircut on all floating rate residential mortgage backed securities (Bank of England).

More recently, a series of US bailouts has forced bondholders to take brutal haircuts on bank bonds as well as the government-organized bankruptcies of Chrysler and General Motors.

Last updated on 7 September 2009.

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