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SHADOW BANKING

Region: Why dont we begin with somebackground on so-called shadow bank-ingthe factors behind its enormousgrowth, and then its collapse during the

financial crisis? Do you prefer a differ-ent term? You use securitized bankingin some of your papers.

Gary Gorton: The term shadow bankinghas acquired a pejorative connotation,and Im not sure thats really deserved.So let me provide some context forbanking in general.

Banking evolves, and it evolvesbecause the economy changes. Theresinnovation and growth, and shadowbanking is only the latest natural devel-

opment of banking. It happened over a30-year period. Its part of a number ofother changes in the economy. And letme give even a little more context, his-torical context. I want to convince youthat shadow banking is not a new phe-nomenon, in a sensethat we have hadprevious shadow banking systems inthe pastand that there is an importantstructure to bank debt that makes it vul-nerable to panic. So, the crisis is not aspecial, one-time event, but somethingthat has been repeated throughout U.S.history.

Before the Civil War, bankinginvolved issuing private moneythat is,banks issued their own currency orbank notes. And this system worked inthe way economists would expect it towork. The private bank money did nottrade at par when it circulated any sig-nificant distance from the issuing bank.Instead, it was subject to a discount, sothat a bank note issued by a New Havenbank as a $10 note might only be worth$9.50 at a store in New York City, forexample.

Such discounts from par reflected therisk that the issuing bank might nothave the $10redeemable in gold or sil-ver coinsby the time the holder tookthe note back to New Haven from NewYork. The discounts from par wereestablished in local markets. But youcan see the problem of trying to buy

your lunch when the cook has to figureout the discount. It was simply hard tobuy and sell things in such a world.

A big innovation in that period was

to back the money by collateral, by statebonds. It turned out that this didntalways work very well because thebonds themselves were risky. TheNational Banking Act then corrects thisby having the government take overmoney and issue greenbacks, or federalgovernment notes backed by Treasuries.That was the first time in American his-tory that money traded at par. That was1863.

The National Banking Acts (therewere two of them) are arguably the most

important legislation in the financialsector in U.S. history. But whats inter-esting, and the reason I bring this up, isthat as that was going on, a shadowbanking sector was developing. And thisshadow banking sector first reallymakes itself felt in the Panic of 1857when depositors run and demand cur-

rency from their checking accountsSo, after the Civil War, there

problem with currency [because grbacks were backed by the federal ernment], but we have this other forbank money: checking accountsw

appears to be shadow banking.It develops into something very

and repeatedly has crises. In the19th century, academics were litewriting articles with titles like Checks Money? in top economics jnals. And in 1910, the National MonCommission, which is the precursthe Federal Reserve System, commis30-some books, one of which is abouextent to which checks are used asrency for transactions. So theyrestudying it in 1910.

Eventually, as you know, wedeposit insurance, which then mchecks safe, so to speak.

Region: There were some efforts to vide deposit insurance prior toFederal Deposit Insurance Corporaof course.

Gorton: Yes, there were state deinsurance schemes that had diffexperiences, and there were propfor federal deposit insurance for quwhile before it was actually ado

Interestingly, FDIC insurance opposed by economists.

THE RISE OF REPO

Region: How does this historical conrelate to shadow banking today?

Gorton: In the last 30 or 40 years, thave been a number of fundamchanges in our economy. One omost fundamental of these has beenrise of institutional investing.

amount of money under managemof institutional investors has just exponentially increasing. These incpension funds, mutual funds, money managers. And these institubasically have a need for a checaccount, if you will. So if youre a institutional money manager, you

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16DECEMBER 2010

Shadow banking has acquired a

pejorative connotation, and Im notsure thats really deserved. ... Banking

evolves, and it evolves because the

economy changes. Theres innovation

and growth, and shadow banking is

only the latest natural development.

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need a place to put $200 million, andyou want it to earn interest and to besafe and accessible. That led to themetamorphosis of a very old security:the sale and repurchase (or repo) mar-ket. Like a check, repo* had been around

for perhaps 100 years, but it was neververy large.

Region: This is in the early 1980s?

Gorton: Well, the early 80s are thebeginning point of a number of devel-opments that are going to come togeth-er. We dont have any data on repoexcept for a small subset of firms, so wecant document many of the things wereinterested in knowing. Ill come back tothis problem later, perhaps: the meas-

urement problem in macroeconomicsgenerally.But these firms basically would like

to have a checking account, and a repoprovides that in the following sense.Lets just start with a regular bank. If youput your money in a checking accountin a bank, they pay you, say, 3 percent;they take your money and lend it out at6 percent. They make the spread.Banking is a spread business.

Repo works similarly. You take your$200 million to the bank, to LehmanBrothers, say. You deposit it, so to speak,

overnight so you can have access to it thenext morning if you want to. They payyou 3 percent. And you want it to be safe,so they give you a bond as collateral. ButLehman earns the interest on the bond,say, 6 percent. And the bond is going toturn out often to be linked to bank loans.

Region: And theres also a haircut,true?

Gorton: There may be a haircut. If youdeposit $100 million and they give you

bonds worth $100 million, theres nohaircut. If you deposit $90 million andthey give you bonds worth $100 million,then theres a 10 percent haircut.

Region: Just to be clear, they dontdeposit those funds in a checkingaccount because

Gorton: Right, because the FederalDeposit Insurance Corporation limit istoo low, just $250,000, and these

deposits are in the tens or hundreds ofmillions.

There are competitors for repo thatthese firms consider and use, but againwe dont know the relative sizes of these.I think now we have a good idea of whatrepo was just before the crisis.

But repothe transaction I justdescribedhas other similarities to thechecking account story. If you put a dol-lar in your checking account and thebank has to keep 10 percent of it onreserve, they lend out 90 cents.

Somebody deposits that 90 cents, thebank can lend out 81 cents (because ofthe 10 percent reserve requirement) andso on. So you end up creating $10 ofchecking accounts for $1 of demanddeposits, assuming theres a demand forloans. Now, that money multiplierprocess is very important because it

means that the amount of endogenocreated private bank money in checaccounts is 10 times the size of thelateral, so to speak, of $1 of governmmoney. So, in a traditional banpanic, if everybody wants their $10 b

theres only $1. And thats the problem

Region: The Jimmy Stewart proble

Gorton: Right, the Jimmy Stewart plem. And that can happen in repwell because if youre Lehman andthe depositor, and you give me a boncollateral, I can use that bond sowhere else. So there is a similar momultiplier process.

Region: Thats rehypothecation, r

One of my favorite new words.

Gorton: Yes, its become very poplately [laughs]. So, if shadow banrefers to the growth of this typmoneyand its not controversial toits money; it was counted in M3in order for this to grow, you havhave the collateral, and collateracourse, like in the pre-Civil War eraturn out to be risky bonds.

The reason for this is that there aenough high-quality bonds. Prior tocrisis, there were not enough Treasu

Many Treasuries are owned by foreers and are not available to be userepo. And collateral is also demanfor posting in derivatives transactand for clearing and settlement. most common way of dealing counterparty risk is to ask for collatSo the demand for collateral is pesive. For repo to grow, you needehave more collateral.

The other important aspect of sow banking is related to the way theditional banking sector evolved,

decline of the traditional banking bness model. The traditional model I issue checking accountsand inold days, I didnt have to pay intbecause I had a monopoly on that. I would lend the money out.

A lot of things changed. Money mket mutual funds took market s

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If youre a large institutional money

manager, you may need a place to put

$200 million, and you want it to earn

interest and to be safe and accessible.

That led to the metamorphosis of a very

old security: the sale and repurchase

(or repo) market. Like a check, repo

had been around for perhaps 100 years.

*Terms highlighted in blue are defined in aglossary on pages 2829.

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from banks because they offered inter-est. Eventually, checks are going to payinterest, which makes banks cost of cap-ital go up. Junk bonds take away a prof-itable form of lending for banks. And so,starting in the 1980s, the traditional

bank lending business didnt work any-more.

Region: They lost what you refer to ascharter value. Could you explain that abit?

Gorton: Right. The way thats describedin the economics literature is that thecharter value, which is the title to earnsome monopoly profits because of limit-ed entry into banking, disappearsbecause of competition and innovation.And thats not so surprising, right?Thats something that happens all thetime: Theres innovation.

But what happened this time wasinteresting because the regulatoryresponse was to allow banks to compete,and allowing banks to compete meantthat the charter value went down evenmore. So traditional banking needed tohave an innovation in order to maintainitself as an industry. And the innovationwas securitization.

GROWTH OF SECURITIZATION

Region: Ive seen your data from theearly 90s showing declines in profitabil-ity of U.S. banks, or their low profits rel-ative to Japanese banks that entered theU.S. market and competed with them. Isthere more recent empirical evidence ofreduced profitability in traditionalbanking relative to shadow banking?

And would you elaborate on why andhow securitization evolved?

Gorton: The empirical question is very

hard to answer because in equilibriumthese firms do things to be profitable, soin traditional banking you can see adecline in profits, but the decline goesaway because theyre doing new, prof-itable activities.

Securitization basically allows thetraditional banks to finance their loans

by selling them rather than holdingthem on balance sheet, and the source of value here is avoidance of bankruptcycosts. A firm that originates loans doesso by lending money to any number ofborrowersboth corporate and con-sumerand it then selects a large port-folio of its loans to sell, in a very specif-

ic legal sense, to a special purvehicle, an entity it creates for thatprecise reason. The main advantadoing soof establishing the SPVlegally selling the loans to itis thaarrangement circumvents the

associated with bankruptcy.Let me briefly elaborate on the ap

of these SPVs. Theyre a kind of rfirm, a set of rules governing the flows. No one works there, and theno physical location. They own land are obligated to pay their liabilwhich are the asset-backed securthey issued to buy the loans. But iSPV cant pay those liabilitiesiunderlying loan portfolio doesnt geate enough cash to make the coupayment due on the asset-backed srities bondit doesnt trigger an eof default. Instead, the liabilities amtize early. That is, the principal ments are made ahead of scheduleover time. So again, for the firmoriginates the loans, the source of vis the avoidance of bankruptcy cost

Institutional investors, inclumoney market mutual funds amothers, buy portions (called tranchof these loans at prices that reflect credit ratingsAAAsenior, BBB anonand thats how the traditbanking sector is linked to this se

tized, or shadow, banking sector. elaborate system of securitizaevolved over 30 years, and it endeproducing a large part of the collathats used for repo.

Region: What youve just descrithenthis intricate process of investors buying asset-backed secuthat are based on portfolios of lgenerated by banks or loan origtorsis the connection between repthe shadow banking sector, and the

sumer and business loans that are onated in traditional banking.

Gorton: Right. Lets just review how operates. For repo to work, firmswant to borrow cash (to finance activities) must hold a sufficient amof bonds on their balance sheets t

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Securitization basically allows the

traditional banks to finance their loans

by selling them rather than holding them

on balance sheet, and the source of value

here is avoidance of bankruptcy costs. ...

Because of this link, traditional banking

and shadow banking are integrated. ...

Traditional banking funds itself in large

part by selling loans to firms that use

those loans for collateral for this other

category of loans. This is a crucial,

crucial point.

I would describe shadow banking as

the rise to a significant extent of a very

old form of bank money called repo,

which largely uses securitized product

as collateral and meets the needs

of institutional investors, states and

municipalities, nonfinancial firms for a

short-term, safe banking product.

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used as collateral when depositors(effectively lenders: money market mutu-al funds, other institutional investors orcorporations seeking a place to save largequantities of cash in the short term)arrive to put their money in the bank

the firm wanting to borrow cash. In theexample I used earlier, the bank wasLehman Brothers, but most financialfirms using repo didnt collapse as dra-matically as Lehman did.

So those bonds, if theyre securitizationbonds, asset-backed securities, are linkedto portfolios of bank loans. Because of thislink, traditional banking and shadowbanking are integrated. Theyre part of thesame system. Traditional banking fundsitself in large part by selling loans to firmsthat use those loans for collateral for thisother category of loans.

This is a crucial, crucial point.Because if you think about the currentunemployment rate and wonder, Well,banks arent lending. What could wedo? A very practical, constructive stepwould be to help the securitization mar-ket, which would at the same time helptraditional banks.

The fact is that this market is broken.And shadow banking very importantlyis not a separate system from tradition-al banking. These are all one bankingsystem. It happened that repo was con-

centrated in certain firms, many ofwhich were the old investment banks,but also in the large quasi-investmentbanks or commercial banks.

In summary, I would describe shad-ow banking as the rise to a significantextent of a very old form of bank moneycalled repo, which largely uses securi-tized product as collateral and meets theneeds of institutional investors, statesand municipalities, nonfinancial firmsfor a short-term, safe banking product.

Region: So, its a valuable innovation.

Gorton: Exactly. Its a valuable innova-tion.

Region: And thats why you might want aterm other than shadow banking thatdoesnt have a pejorative connotation.

Gorton: Yes. Of course, the problemwith repo and shadow banking is thatthey have the same vulnerability thatother forms of bank money have. Wecan talk at great length about what thatvulnerability is, but loosely speaking, its

prone to panic. Looking back at history,think about how long it took to devise asolution to the first banking panic relat-ed mostly to demand deposits. That wasin 1857. It wasnt until 1934 that depositinsurance was enacted. Thats 77 yearswhere were tryingto understand demanddeposits and figure out what to do.

The situation that were in now, seri-ously, is one where we are back in about1860: Weve just had a big crisis, andwere trying to figure out what to do. Wecan only hope that it doesnt take 77years to figure it out this time.

SENSITIVE/INSENSITIVETO INFORMATION

Region: That brings us to the question ofwhat did cause the collapse. You write alot about information asymmetryregarding debt, and how panics arecaused by the status of debt shiftingfrom information-insensitive to infor-mation-sensitive. What role did informa-tion asymmetries play in the financialpanic? And what is this distinction

between debt that is sensitive or insensi-tive to information?

Gorton: I should say first that I think its very important for economists to bevery precise with these terms. For exam-ple, the term crisis. I think its used ineconomics very loosely; and certainlyinformally, people think of a crisis asjust a bad event. But I would distinguishbetween global financial crises and badevents such as the collapse of theInternet bubble, the Asian crisis, the

1987 stock market collapse, the S&L cri-sis. These were not global financialcrises. Theres a distinction betweenthese two.

Now, formally, what is the distinc-tion? I think economists need to thinkabout that as well. Global financialcrises are about debt. About debt. But,

obviously, we need to have a theodebt to understand why people wuse a security, bank debt, and howcould lead to a crisis.

In the literature so far, I think wall had trouble with this because

models of crises assume debt andmodels of the optimality of debt rhave little to do with crises. This iunfortunate situation to be in as a fession. In my work with Tri Vi Dand Bengt Holmstrm, we developidea, that you mention, of the optimty of debt arising from its informainsensitivity. Roughly speaking,argument for the optimality of desimply that its easiest to trade if yosure that neither party knows anytabout the payoff on the debt.

Go back to the Free Bankingagain. The Free Banking Era workethe sense that the discount from pwhich the notes traded was correct efficient market sense. But the probwas that when you went to buy ygroceries in a nearby town, somebhad to figure out what the discountand you could never be sure thadiscount was correct and you webeing taken advantage of. Meanwthe cashier is looking up in this newspaper to figure out what thecount is. And thats not an efficient

to transact. That was exactly the plem that the Free Banking Era law to prevent, by sufficiently backingnotes so you wouldnt have to do th

Region: You wanted the notes valube information-insensitive.

Gorton: Yes, information-insensiYou wanted it to be the case that I cto your store and I offer you BanNew Haven notes in Wisconsin,you just say fine and you take th

And that happened once the NatiBanking Act created federal moneyThat intuitive logic applies to rep

well. Nobody wants to be given collal that they have to worry about. the mechanics of how repo worexactly consistent with this. Firmstrade repo work in the following

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The repo traders come in in the morn-ing, they have some coffee, they go totheir desks, they start making calls, andin a large firm theyve rolled $40 to $50billion of repo in an hour and a half.Now, you can only do that if the deposi-

tors believe that the collateral has thefeature that nobody has any privateinformation about it. We can all justbelieve that its all AAA.

This is a feature of an economy that isfundamental. It is fundamental that youhave these kinds of bank-created trad-ing securities. And the fact that its fun-damental and that you need these is notwidely understood in economics. Imean, if you take a standard macromodel, a dynamic stochastic generalequilibrium model, this is a neoclassicalgrowth model that has no technologyfor transactions.

Region: Money plays no role.

Gorton: Bank money plays no role.Theres no chance that such a modelcould ever explain a crisis. Zero chance.And I should add that its not a matter ofputting in a friction. The nomencla-ture thats used is very interesting. Yousay, Its a friction. We need a friction.

In welfare terms, the fact that yourmodel can explain good times doesnt

get a lot of weight if it cant explain whathappens in a crisis where there is a hugewelfare loss.

BETTER DATA: BETTER MODELS

Region: In Chairman Bernankes recentspeech about what the financial crisismeans for economics, he suggests thatbecause standard macro models weredesigned to understand noncrisis peri-ods, they dont have much to say aboutcrisis or financial instability.1

I gather you would agree?

Gorton: The way standard models dealwith it is, I think, incorrect. A lot ofmacroeconomists think in terms of anamplification mechanism. So you imag-ine that a shock hits the economy. Thequestion is: What magnifies that shock

and makes it have a bigger effect than itwould otherwise have? That way ofthinking would suggest that we live inan economy where shocks hit regularlyand theyre always amplified, but everyonce in a while, theres a big enoughshock So, in this way of thinking, itsthe size of the shock thats important. Acrisis is a big shock.

I dont think thats what we observe inthe world. We dont see lots and lots of

shocks being amplified. We see a fewreally big events in history: the recent cri-sis, the Great Depression, the panics ofthe 19th century. Those are more than ashock being amplified. Theres somethingelse going on. Id say its a regimeswitcha dramatic change in the way thefinancial system is operating.

This notion of a kind of reswitch, which happens when youfrom debt that is information-insetive to information-sensitive is diffeconceptually than an amplificamechanism. So theres a prob

Conceptually, the notion of adthings to existing modelsa frictioan amplification mechanismrethis overall paradigm in which finaintermediation generally has no rodont think that is going to work.

Region: Is this a preview of what ybe covering in your keynote tonighthe University of Wisconsin SchoBusiness Conference on MoBanking and Asset Markets]?

Gorton: No. Ill try to convince peopa few things about the crisis in mytonightin particular, that the pannot a special, one-off event, but is dthis structural feature of bank moneywe have been talking about. But to unstand that requires doing some ththat are painful for most economists

One thing is that you have to unstand a lot of institutional detailimportant to do that so you can unstand whats really going on. Its notthe institutional detail per se is so vable to understand. Were not consul

But to penetrate the details to the pthat you can see the commonabetween, say, different forms of money, so you can see whats rgoing on, requires an understandinthe institutional detail which is nthink, widely appreciated.

The other thing is that its important to document and underswhat happened by getting data. We write theories just by reading the npaper. You have to go find out whatpened, and thats much harder.

respect to the crisis, theres no placecan go and just download data.example, there is no source for data; the New York Fed only codata on repo that the primary dealewith the New York Fed.

Region: But not on haircuts, true?

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The recent crisis, the Great Depression,

the panics of the 19th century. Those aremore than a shock being amplified.Theres

something else going on. Id say its a

regime switcha dramatic change in the

way the financial system is operating. ...

The notion of adding things to existing

modelsa friction or an amplification

mechanismretains this overall paradigm

in which financial intermediation generally

has no role. I dont think that is going

to work.

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Gorton: They never collected haircuts.Now they do. The important data arehard to find. One thing Ive done isspend a lot of time trying to get data.And you get data by appealing to thecivic duty of traders and your friends

and former students.

Region: People youve worked with inthe financial industry, or taught.

Gorton: Yes. Thats how you get data.You tell them, Its very important, and Iknow your company is significant. So,again, its the endeavor of finding data.People just have to be encouraged to doit. I encourage my students to do it.

THE COLLAPSE OF REPO

Region: Lets go back to causes of the cri-sis, if we could. Why did the repo mar-ket collapse? What caused the transitionfrom insensitivity to sensitivity of debt?Why did what seemed to be a house ofbricks turn into a house of cards?

Gorton: It looks a lot like the 19th centu-ry banking panics in that sense. Thosepanics tended to happen at businesscycle peaks. Information arrived, toldyou that a recession was coming. And ifthat shock was above a certain thresh-

old, there was a panic. There was nevera panic when that shock wasnt over thethreshold, but every time it was over thethreshold, there was.

The same thing happened this time.There was a shock. The shock by itselfwasnt big enough to cause a globalfinancial meltdown. The shock was thathouse prices didnt rise.

Region: And that was reflected in theABX index. That was the new informa-tion.

Gorton: Yes, the house price decline hadthe biggest impact on subprime mort-gages, and thats the information thatwas revealed by trading the ABX index,although I think it was widely knownand understood, probably, beforehand.But the question is, again: How could

that shock lead to such a big crisis?Remember: At the time, subprime

mortgages outstanding totaled about$1.5 trillion. If all of that had defaultedwith zero recovery, that would not havebeen a global financial crisis. That

would have been a problem, becausepoor and minority people received adisproportionate share of these sub-prime mortgages. And surely there wereproblems with all sorts of other thingsunderwriting standards, broker incen-tivesbut they didnt constitute orcause a global financial crisis. So whathappened?

What happened, I think, is that thedepositors in the repo market got nerv-ous to the extent that the only way toprotect themselves against agents pro-

ducing private information was to askfor a buffer. Lets go back to the repomarket. In the repo market, I give you$100 million; you give me $100 millionworth of bonds. Lets say those bondsare AAA, credit-card-linked bonds, anasset-backed security. The only way Ican lose as a depositor is if you fail. I amthen allowed to unilaterally terminatethe agreement, and I go to sell my bondsand I fetch less than $100 million.

Now, if the shock causes me to worrythat when I sell my bonds somebodywill have produced private information

(because now, unlike before, its prof-itable to do that), then I can protectmyself by saying, Im not going to giveyou $100 million. Im only going to giveyou $80 million, and you give me $100million of bonds as collateral.

So that gives me a 20 percent bufferagainst that possible loss. For you, how-ever, thats a big problem because youwere financing $100 million with mebefore and now youre only financing$80 million, and so now you have tofinance the other $20 million some-

where else.

Region: This was the increase in haircutsthat occurred in the early stages of thecrisis.

Gorton: Right. This was the increase inhaircuts. An increase in haircuts is a

withdrawal from this banking sysThere are several studies that allow put some numbers on this. WAndrew Metrick, Ive estimated theof the repo market; two economisthe BIS [Bank for Internati

Settlements] have estimated the sithe repo market independently andseparate way; and theres an [International Monetary Fund] ecmist who has also estimated the sithe repo market, again, with a tmethod. And we have another imtant piece of information, a very gsurvey of the European repo mawhich is widely viewed as being msmaller than the U.S. market. So, iflook at all of this information, the sithe repo market, conservatively, was

trillion.

Region: This is justrepo?

Gorton: Right, just repos. Never mabout asset-backed commercial por the rest of it.

Region: So shadow banking iswashuge. Possibly even larger standard, regulated banking.

Gorton: The total assets in the regulbanking sector in the U.S. are $10

lion.Lets do just a back-of-the-enve

calculation: If haircuts go from 0 cent to 30 percent, on average, thattrillion the shadow banking systemto raise. The run is that depositors w$3 trillion. Theres no place to getrillion. And we know what happover the course of the crisis. Theends up buying $2 trillion, and cmercial banks end up buying $1 trilBut the process of transferring tassets is very painful.

Region: Whats the current statushadow banking?

Gorton: Regulated banks are sittinover $1 trillion of reserves and rdont lend. And since theyre not ling, theres not a lot to securitize,

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the securitization market is a shadow ofits former self. The banking system isreally in a shambles. You can see in allthe current issues about foreclosure thatthe bleeding is continuing. Its not thatthe system is healthy and it wont lend.Its not healthyeither the traditionalsystem or the shadow banking system.

But I would emphasize that there aresome constructive, positive things thatwe could do in this area.

REGULATORY REFORM

Region: Good, lets talk about regulatoryreform. In your paper with AndrewMetrick, you say that the Dodd-FrankAct takes some positive steps but thatthere continue to be three major gaps,and you offer what Ill call the Gorton-

Metrick proposal of narrow-fundingbanks.2 Could you elaborate on what youseeas gaps in Dodd-Frank and tell us whyNFBs could address that? Also, what areyour thoughts about Fed GovernorTarullos response to your proposal?3

Gorton: A constructive policy I thinkwould be a reform that did two things.First, it would remove the vulnerabilityof the repo market to runs. And second,it would also re-create confidence insecuritization so that we could get the

banking system functioning again.Those would be the two things that youneed to accomplish for a constructivereform.

Now, Dodd-Frank doesnt do that.Dodd-Frank addresses some things thatperhaps needed to be addressed: someinfrastructure issues, consumer protec-

tion. For these things, it depends onhow the rules are written. Well see whathappens. But with regard to the coreissue, I think its like what happenedafter every panic in the 19th century.Reforms were passed, and we went on to

the next crisis.

Region: And we tend to fight the lastbattle.

Gorton: Not really fight the last battle. Idont think it is understood how we wonthe last battlesthat is, how depositinsurance worked or why the NationalBanking acts worked. Today there is noneed to fight these battles again. Weshould have learned, and we should not just repeat the 19th century, duringwhich we had ineffective reforms afterevery panic.

Region: The historical quotations thatyou often use to begin your papers areamazing in their similarity to currentevents.

Gorton: Right. People point to the failureof certain firms. They point to specula-tive activity in certain railroad stocks orland. And the structural commonalitiesthey miss. Thats why its so ironic, andalmost tragic, that deposit insurance

was passed as a populist mandate, overthe objections of bankers, economistsand FDR.

So, Dodd-Frank is well meaning, itswell intentioned, it does some goodthings. But does it solve the problem?No. Does it understand the problem?No. Metrick and I propose, broadlyspeaking, that we address three things:money market mutual funds, where wehave nothing new to say so we leave thatone aside, but we want to bring securiti-zation under the regulatory umbrella

because its used as collateral. If the gov-ernment doesnt oversee it, then wewont have high-quality collateral thatscreated that people will have confidencein, in the sense that its information-insensitive.

We want all securitized product to besold through this new category of banks:

narrow-funding banks. The NFBsonly do one thing: just buy securitproducts and issue liabilities. The

is to bring that part of the bansystem under the regulatory umband to have these guys be collacreators.

A reasonable question would be: doesnt the government create collatWell, the Treasury has fiscal issuesthats what determines whether theyrow or not, and we dont want tothese things up. And the Fed in princould create collateral, and we talk athat in the paper. But short of thecreating all the collateral, it seems d

able to oversee the creation of collaby the private sector.The second part is also straigh

ward. If were going to have prmoney creation in the form of repowant it to be done in regulated ent just like demand deposits. We want nonbanks to do a lot of repo.

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We want all securitized product to be

sold through this new category of ban

narrow-funding banks. The NFBs can o

do one thing: just buy securitized prod

and issue liabilities. The goal is to brin

that part of the banking system under

the regulatory umbrella and to have th

guys be collateral creators.

Regulated banks are sitting on over

$1 trillion of reserves and really dont lend.

And since theyre not lending, theres not

a lot to securitize, and the securitization

market is a shadow of its former self. ...

Its not that the system is healthy and

it wont lend. Its not healthyeither the

traditional system or the shadow banking

system.

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However, repo is sort of a lifeblood ofthe financial system, and it has lots ofother uses. So we dont want to outlawits use by hedge funds and all sorts ofother firms. But we then want to regu-late that. There are many details to be

worked out in this proposal. We omitteda lot of the details in order to get outsome of the big ideas.

One of the responses we got was thatthis was a radical proposal. And I wouldpoint out that the National Banking Actwas also a radical proposal. And FDICinsurance was also a radical proposal.When we have an event as extreme asthe crisis, a nonradical proposal proba-bly isnt going to work. So I dont takethat as a criticism. I take that as sort of asuperficial response.

Region: You dont want a bandage whenyou need surgery.

Gorton: Exactly. Now, Governor Tarullosresponse, I thought, was fantastic. Ifound it very thoughtful. He brought upgreat points. I dont disagree with manyof those points.

I woulddisagree with the notion thatit might have unintended consequencesso we should not adopt the NFB pro-posal. Anything you do might haveunintended consequences. Right now, I

think, if we dont act, we willhave a lostdecade. Getting the banking systemfunctioning; well, theres some urgencyto that. So Im willing to go for that anddeal with the unintended consequencesrather than not do anything. Im notsure that he would disagree with that,but he refers to unintended conse-quences.

Region: He also said, I believe, that weneed to do a cost-benefit analysis of theproposal. How do the benefits compare

with the costs of reforming securitiza-tion and major changes in regulatorylaw?

Gorton: Yes, but how long is that goingto take? Twenty million Americans areout of work, so theyll be waiting for thestudy.

Region: So youre saying this is ER sur-gery, not elective.

Gorton: Right. Theres some urgency tothinking about this. People inWashington would, I hope, be open-

minded to these kinds of ideas justbecause the alternative seems so bleak.

DODD-FRANK, THE FSOCAND MEASUREMENT

Region: A big concern at theMinneapolis Fed is whether Dodd-Frank deals adequately with moral haz-ard. It sets up resolution authority; itestablishes the Financial StabilityOversight Council, which had its firstmeeting about a month ago. The FSOCs

mandate is responding to emergingrisks to the stability of the United Statesfinancial system.

Given what you know about the his-tory of U.S. regulatory efforts and bank-ing panics, whats your take on whetherthe FSOC is likely to be able to respondto emerging risks, rather than looking atthe old ones, specifically in terms ofmoral hazard?

Gorton: Let me set moral hazard asidefor a moment. The question you raise isone that I think of in terms of measure-

ment. Measurement is at the root of sci-ence, and it ought to be at the root ofeconomics. One of the problems that Ithink weve been aware of for a while isthat when you have derivatives, tradi-tional methods of measuring are noteffective.

Think about how we measure thingsnow. We have the call reports; we haveFlow of Funds; we have nationalincome accounting; we have GAAP.And these methods are fine when youlive in a world where the risks of cash

flows are put together in a security. Butthats not the world that we live in. Sohaving a picture of the economy nowthats consistent with these innova-tionsderivative securitiesis veryimportant, and that means that thesemeasurement systems need to berethought.

I h av e a p ap er wit h MaBrunnermeierand Arvind Krishnamuwhere we broach these issues.4 I t

these issues ought to be at the toeconomists agendas, but theyreissues that anybody thinks about, re

An oversight council like the Fhas no chance of understanding thing if we dont have better measuresystems. Thats why in Dodd-Frank,set up the Office for Financial ReseAnd this goes to the roots of economright? Think of Burns and Mitchebusiness cycles. Think of Kuznetnational income accounting. And tare economists who think about m

uring productivity. Now its time foto work on measuring risk.Go back to macroeconom

Macroeconomics as a paradigm in part is determined by what is measuIf I told you that I had a 30-year pdata set of firms by sector and I haddeltas of the change in value

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23 DECEM

When you have derivatives, traditional

methods of measuring are not effectiveSo having a picture of the economy no

thats consistent with these innovations

derivative securitiesis very important.

An oversight council like the FSOC has

no chance of understanding anything if

dont have better measurement systems.

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respect to certain systemic risks andidiosyncratic risks, people would cali-brate models to measures of risk, right?

The way models are built, and theway people think, is determined in largepart by what we measure. Its deter-

mined by Kuznets, basically. So its hardto even imagine how youre going tobuild models if we dont measure thingsthat are more directly associated withwhat we would like to know.

So we wrote this little paper aboutmeasurementits really half a paper atthe moment; its a draft. And my coau-thors organized this NBER [NationalBureau of Economic Research] confer-ence a couple of weeks ago in New York.(I told them they should do it; theyreyounger than me [laughs].) And it was areally interesting conference, I must say.But the reason it was so interesting isthat everybody was totally confused.People had all kinds of interesting ideas,I thought, about what to measure.

Region: Thats how new the idea was.

Gorton: Exactly, thats how new it was.You go to most conferences and yourehearing finished papers, and you cankind of agree or disagree, whatever, butits going to be sent off to a journal to bepublished, if its not already sent off, and

pretty much the disagreement is verypredictable. We all know who disagreeswith whom about what.

This was one of the few times, I think,that generated a really productive dis-cussion. I think its great that people arethinking about these things. This isabsolutely critical. This is critical toeverything. And its unfortunate thatyoung people arent interested in this.You cant get tenure working on meas-urement. You cant get published in top journals working on measurement. Its

not theory.So I think the oversight council hasthis problem. Now, theyre not going tobe able to prevent crises, because youcant prevent a banking panic by identi-fying risks. You need to prevent thebank money from being vulnerable topanic. If you had had this oversight

council in 1930, or even 1920, would ithave prevented the banking panics ofthe Great Depression? No.

But its still a good thing. I think its agood thing to understand where risk isand to be able to think about it and to be

foresightful. But its not going to work ifyou dont have new measurement systems.

But I should get back to your ques-tion about moral hazard ...

CREATING COLLATERAL,NOT INSURANCE

Region: Is your idea of narrow-fundingbanks essentially opting to create collat-eral rather than insuring repo markets,which might generate moral hazard?

Gorton: Yes, because collateral is theother way of thinking about it. Its easyto just insure everything [laughs].

Metrick and I have the view that itwould be better to go for the model ofthe National Banking Act or the FreeBanking Act, to try to create viable col-lateral, rather than to try to create char-ter value, in order to keep moral hazardin check.

Now, narrow-funding banks mayhave charter value as well, but were notrelying on that. The interesting thingabout moral hazard is that its, I think,

kind of a lazy argument. No one has eversaid that moral hazard was at the root ofall the 19th century banking panics.

Region: But that was before depositinsurance.

Gorton: Yes, it was before deposit insur-ance, but there were clearinghouses andyou could free-ride clearinghouses, andno one has argued that anybody did.And its also, I think, important toexplain why deposit insurance worked

from 1934 to 2007. And the argument inthe literature is that there was positivecharter value. So the argument is notthat you had moral hazard; its that char-ter value went down. That was the prob-lem. You had these innovations infinance that decreased charter value.

So the issue is to somehow accept the

fact that the world was differentafact, betterbecause of shadow bing, but to aim at the vulnerabilitshadow banking. The way we sawbefore was with either insurance orlateral.

Its a similar thing with termstoo big to fail. The banking systemtoo big to fail. Thats why we allosuspension of convertibility [in the and early 20th centuries]. Suspensioconvertibility by banks, prior to the

was always illegal, but it was nenforced because nobody wanted touidate the banking system.

Now you could say, Well, its jmatter of commitment. If we ccommit to liquidate the banking sys just one time, then they would ncreate private money. We would

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24DECEMBER 2010

After the fact, things always look clearer

dont they? Monday morning. People mstatements like, Obviously, there was t

much leverage.Thats like saying the

patient died because his heart stopped

beating or inflation is caused by prices

going up. Obviously, there was leverage

Thats why I said before that you need

a theory of debt; you need to explain w

theres this debt and what is the purpos

of having this debt.

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have currency. Well, that was the wholeproblem in the 19th century: the inelas-ticity of currency. So if you dont want pri-vate money, why dont you just come outand say it? We dont want private money.

We could eliminate private money, at

least for a year or two until it popped upin some other form. So the too-big-to-fail argument, again, its not clear to methat its really a moral hazard issue somuch as it is that when you have a bank-ing panic, the system is insolvent.

After the fact, things always lookclearer, dont they? Monday morning.

People make statements like, Obviously,there was too much leverage. Thats likesaying the patient died because his heartstopped beating or inflation is caused byprices going up. Obviously, there wasleverage. Thats whyI said before that you

need a theory of debt; you need toexplain why theres this debt and what isthe purpose of having this debt. Doesthat security, which is optimal, have con-sequences that are socially suboptimal ornot? Whats the problem? To makeprogress, we need to say more ratherthan just repeating these things.

FINANCIAL INNOVATION

Region: In your writing, you drawanalogy between banking and electty. When these systems work weldont care how they work. But w

they fall apart, then we suddenly rethat we dont understand them. Tcertainly become clear in the recentsis as researchers l ike you explained the complexity of finainnovations.

Is the pace of financial innovatiooverwhelming that it inevitably lea

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25 DECEM

More About Gary B. Gorton

Current Positions

Professor of Finance, School of Management, Yale University, since 2008

Professor of Economics (secondary appointment), College of Arts andSciences, University of Pennsylvania, since 1996

Sloan Fellow, Wharton Financial Institutions Center, since 2000

Research Associate, National Bureau of Economic Research, since 1990

Previous Positions

Robert Morris Professor of Banking and Finance,Wharton School,University of Pennsylvania, 200308; Liem Sioe Liong/First Pacific CompanyProfessor of Finance, 19982003; Professor of Finance, 199598;Associate Professor of Finance, 199095;Assistant Professor of Finance,19841990

Director, Banks and the Economy Program, Federal Deposit Insurance

Corp., 200304

Adviser, Federal Reserve Bank of Philadelphia, 199495; Senior Economist,1984; Economist, 198184

Houblon-Norman Fellow (first non-English winner), Bank of England, 1994

Visiting Associate Professor of Finance, Graduate School of Business,University of Chicago, 199293

Professional Activities

Member, American Finance Association,American Economic Association,Economic Society

Consultant, Board of Governors of the Federal Reserve System, Bank ofEngland, Bank of Japan, Central Bank of Turkey, various private firms

Member, Moodys Investors Service Academic Advisory Panel, 200307

Foreign Editor, Review of Economic Studies, 200207

Editor, Review of Financial Studies, 19972000

Director,Western Finance Association, 19972000

Editorial Board Member and Referee, numerous professional journals,since 1993

Publications

Author of scores of theoretical and empirical articles on banking andbank regulation, securitization, stock markets, commodity futures, assetpricing and corporate control issues, including the following:

Slapped by the Invisible Hand: The Panic of 2007, Oxford University Press,2010

Security Price Informativeness with Delegated Traders (with Ping Heand Lixin Huang) in American Economic Journal: Microeconomics,November 2010

SEC Regulation Fair Disclosure, Information, and the Cost of Capital(with Armando Gomes and Leonardo Madureira) in Journal of CorporateFinance, June 2007winner of the Geewax, Terker & Co. Prize inInvestment Research and the Distinguished Paper Prize, special issueof the Journal

Equilibrium Asset Prices under Imperfect Corporate Control (withJames Dow and Arvind Krishnamurthy) in American Economic Review,June 2005winner of the Western Finance Association Best CorporateFinance Paper Prize

Capital, Labor, and the Firm: A Study of German Codetermination(with Frank Schmid) in Journal of the European Economic Association,September 2004winner of the Hicks Tinbergen Medal from theEuropean Economic Association for the best paper published in itsJournalduring 2003 and 2004

Liquidity, Efficiency, and Bank Bailouts (with Lixin Huang) inAmerican Economic Review, June 2004

Education

University of Rochester, Ph.D. in economics, 1983

University of Rochester, M.A. in economics, 1980

Cleveland State University, M.A. in economics, 1977

University of Michigan, M.A. in Chinese studies, 1974

Oberlin College, B.A. in Chinese language and literature, 1973; TunghaiUniversity (Republic of China), 197172

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information asymmetries that can causepanics?

A more positive way to put it mightbe: How can we get the benefits of f inan-cial innovation with less risk?

Gorton: The electricity example hadanother step to it, which is that once theelectricity grid failsa crisisand youhave a blackout, the answer is not thatwe want everybody to become an elec-trician. We dont want to post compli-cated diagrams of electrical circuitry onthe Web for everyone to study. Theanswer is to createto re-createaworld where nobody needs to knowabout electricity. And thats saying, interms of finance, that you want to wantto re-create this world of informationinsensitivity for many securities.

In the crisis, when investors reallystarted to think about how subprimesecuritization works, it turns out to beextremely complicated, even comparedto a standard securitization. You dontwant to have to study that. Not every-body needs to know that.

So this kind of reaction that we needmore transparency is not, I think, theright approach, and I would point outthat deposit insurance did not take thatapproach. Deposit insurance said todepositors

Region: Dont worry about it.

Gorton: Exactly. A traditional financeapproach might be: If we give depositorslots of information, every day theyllmove their deposits to the strongestbank and then banks will have theincentive to be strong, and then every-one will have to spend lots of time doingdue diligence on banks.

Thats insane, basically, and thats notthe approach we adopted, and thats not

the approach we should adopt now.Thats why our proposal about nar-row-funding banks in large part is tosay, Lets create a system of oversightthat doesnt put investors in a positionwhere they have to worry about this.Theyre going to rely, hopefully, on over-sight to do it.

In terms of financial innovation,remember that the trend is toward insti-

tutional money management, delegatedportfolio management.

Region: Which raises principal-agentproblems.

Gorton: True, it does. But it also meansyou and I dont have to worry aboutwhether we want to do a vol swap,right? Somebody else will worry aboutthat. There are, of course, problemswith innovation, and these problems, Ithink, are exactly the things that we

need to detect by the measurement sys-tem I was talking about earlier. And Ithink if you have the measurement sys-tem, and you have confidence thatyouve removed the vulnerability ofrepo, youre in a world where you canmanage this innovation.

So all this infrastructure: measure-

ment, narrow-funding banks, does repo. This kind of infrastruchas to be built. Itll take a long tbut it is important that it be done.power of recent financial innovatistructured products, credit de

tivesis awesome. I dont thinkits really appreciated. This is a glfinancial system.

VULNERABILITY TO PANIC

Region: But if somebody invents a ficial instrument and the economisdata geeks dont know about it becits brand new, theyre not going to kthey should measure it, true?

Gorton: In our proposal for measment, we propose a big supplemenessentially, the call report, but itall financial firms, where we say, want to know the change in the vof your firm and your liquidity ptions, which we define in a cerway. If the following happenshing prices go down by 2 percent, 5cent, 10 percent, 15 percent, 20 perand so onhow does your vchange? And we ask you 200 questWe also drafted a questionnaiwont bore you with all the detailsits the sensitivity to different risk

we dont ask you about the afinancial instrument; but if that ficial instrument causes your sensitto this risk to go up, and we see that happens to every bank, thenknow something.

Its not perfect, but gettingmeasurement system into the 21st tury is the logic of it. But, agawould point out that the overriissue here, I think we should unstand, is the vulnerability of bmoney to panic. Thats the issue

not that other things are unimporBut we havent had trouble withother things in the sense of a glfinancial crisis.

If you had brokers cheating pepredatory lending, declines in unwriting standards, or you dontcredit derivatives or something, wh

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26DECEMBER 2010

So all this infrastructure: measurement,

narrow-funding banks, who does repo.This kind of infrastructure has to be built.

Itll take a long time, but it is important

that it be done. The power of recent

financial innovationstructured products,

credit derivativesis awesome. I dont

think that its really appreciated. This is

a global financial system.

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er it is, those things per se are not aglobal financial crisis. And its the glob-al financial crisis that is the first-ordereffect to be dealt with. And I think weknow, we shouldknow by now, what theproblem is and what to do. My concernis that well go another 77 years beforewe figure it out.

Region: Thats a good place to stop. Letshope your concern is not well founded.

Gorton: Yes, lets hope.

Region: Thank you so much.

Douglas ClementNov. 5, 2010

Endnotes

1 Bernanke, Ben S. 2010. Implications ofthe Financial Crisis for Economics. Speechat the Conference Co-sponsored by theCenter for Economic Policy Studies and theBendheim Center for Finance, Princeton

University, Princeton, N.J., Sept. 24. Onlineat http://www.federalreserve.gov/ newsevents/speech/bernanke20100924a.htm.

2 Gorton, Gary, and Andrew Metrick. 2010.Regulating the Shadow Banking System.Social Science Research Network. Onlineat http://papers.ssrn.com/so13/papers.cfm?abstract_id=1676947.

3 Tarullo, Daniel K. 2010. Comments onRegulating the Shadow Banking System.Speech at the Brookings Panel on EconomicActivity, Washington, D.C., Sept. 24. Onlineat http://www.federalreserve.gov/newsevents/speech/tarullo20100917a.htm.

4 Brunnermeier, Markus K., Gary Gortonand Arvind Krishnamurthy. 2010. RiskTopography. Online at http://www.kellogg.northwestern.edu/faculty/krisharvind/papers/risk-topography.pdf.

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27 DECEM

The overriding issue here, I think we

should understand, is the vulnerabilityof bank money to panic. Thats the issue.

Its not that other things are unimportant.

But we havent had trouble with the

other things in the sense of a global

financial crisis.

For the complete interview, including Gortons thoughts on asset pricebubbles and the future of economics, go to minneapolisfed.org.

For further reading, see

Gorton, Gary. 2010. Questions and Answers about the FinancialCrisis. Social Science Research Network. Online athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1557279.

Gorton, Gary. 2008. The Panic of 2007. Prepared for the FederalReserve Bank of Kansas City, Jackson Hole Conference. Online athttp://www.kc.frb.org/publicat/sympos/2008/gorton.08.04.08.pdf.

Haltom, Renee Courtois. 2010. Out from the Shadows. Region Focus,Third Quarter, at www.richmondfed.org and athttp://www.richmondfed.org/publications/research/region_focus/2010/q3/pdf/feature3.pdf.

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AAAThe highest credit rating given by debt agencies such

as Standard & Poors and Moodys. An AAA ratingallows a corporation or government to borrow at lowinterest rates.

ABX indexAn index that tracks the performance of a basket ofcredit default swaps based on 20 bonds that consistof U.S. subprime home mortgages. Credit defaultswaps are like insurance contracts that allow buyersand sellers to trade risk. ABX contracts allowtraders and investors to take positions on subprimesecurities without actually holding them. A declinein the ABX suggests a decline in confidence that theunderlying subprime mortgages will be repaid as

expected.

Asset-backed securitiesBonds backed by cash flows from a pool of specifiedassets in a special purpose vehicle rather than by thegeneral credit of a corporation. The asset pools may beresidential and commercial mortgages, automobileloans, credit card receivables, student loans and otherasset classes.

Call reportA quarterly report of income and financial conditionsthat commercial banks are required to file with their

designated federal and state regulatory agencies.

Flow of FundsA set of accounts used to follow the flow of moneywithin the economy. The Flow of Funds analyzes dataon borrowing, lending and investment among house-holds, businesses and government bodies. In theUnited States, the Federal Reserve tracks and analyzesthe flow of funds and provides reports about 10 weeksafter the end of a quarter.

GAAPGenerally accepted accounting principles. GAAP is acode of accounting rules and procedures established

by the American Institute of Certified PublicAccountants.

HaircutA percentage reduction from an assets stated value(e.g., book value or market value) to account for pos-

sible declines in value that may occur before the assetcan be liquidated. Haircuts are often applied to collat-

eral pledged in repo contracts; the collateral is valuedat less than market value in reflection of its perceivedunderlying risk.

Jimmy Stewart problemReferring to the predicament faced by George Bailey,a character played by Jimmy Stewart in the 1946Frank Capra film, Its a Wonderful Life. Bailey is asmall-town banker whose depositors have run on hisbank, demanding their deposits back because theyreworried that the bank is insolvent. Bailey explains tothem that he has only a fraction of their actual cashon hand because most of it has been loaned out inthe form of home mortgages and personal loans.

M3M1, M2 and M3 are (or were) measures of thenations money supply reported by the FederalReserve System. M1 includes currency and demanddeposits at commercial banks. M2 is a broader meas-ure that incorporates M1 but also includes assetssuch as commercial bank savings deposits, depositsat credit unions and noninstitutional money marketfunds, among other components. M3 was broaderstill, but publication of M3 figures ceased in March2006 when the Fed determined that M3 no longerconveyed any additional information about eco-

nomic activity not already embodied in M2. TheFed also ceased publishing one of M3s components,repurchase agreements.

Moral hazardWhen persons or institutions protected from risk arethereby encouraged to take greater risks than theywould if not protected.

National income accountsAn accounting framework used to measure a nationsaggregate economic activity. National accounts broad-ly present the production, income and expenditureactivities of all economic actors (firms, householdsand government bodies). They present both flows dur-ing a period and stocks at the end of that period. In theUnited States, the national income and productaccounts (NIPA) provide estimates for the money

value of income and output respectively, includingGDP.

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Glossary

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Principal-agent problemsThe difficulty of motivating one person, an agent, to

act in the best interests of another, the principal.Problems arise because the agents incentives differfrom the principals, and the principal is unable tofully monitor and direct the agents actions.

RehypothecationFromhypothecateto pledge collateral.Rehypothecationis the reuse (or repledging) of collateral received inone transaction in an entirely unrelated transaction.

RepoAn abbreviation for (sale and) repurchase agreement.A repo is a contract that combines the sale of a securi-ty with an agreement to repurchase the same security

at a specified price at the end of the contract period.Effectively, a repo is a secured or collateralized loanthat is, a loan of cash against a security as collateral.The party that buys the security is operating as alender; the party that sells it is borrowing. The repur-chase price will usually be somewhat higher than theinitial sale price; the difference is the interest earnedon the loan, and is referred to as the repo rate.

Resolution authorityPower to liquidate, in an orderly manner, the assetsand liabilities of a failed financial institution. TheDodd-Frank Act designates the FDIC as the resolu-

tion authority for most financial institutions.

SecuritizationThe process of financing whereby interests in loansand other receivables are packaged, underwritten andsold in the form of asset-backed securities (definedabove). This is done through the creation of a specialpurpose vehicle (defined below) by segregating spec-ified cash flows from loans originated by a firm andselling claims to these cash flows through the SPV toinvestors. Asset securitization began in the 1970s withthe structured financing of mortgage pools. Since themid-1980s, similar techniques have been used tofinance a variety of nonmortgage assets, including carloans and credit card receivables.

Special purpose vehiclesLegal entities established for narrow and often tempo-rary objectives related to regulation, taxation or risk.SPVs are set up by a sponsoring firm specifically to

achieve those objectives. An SPV is not an operatingcompany in the usual sense, but rather a robot com-

panya set of rules without employees or a physicallocation.An SPV can only carry out a specified purpose, a

circumscribed activity or a series of such transactions.Sponsoring firms create SPVs with the specific pur-pose of selling specified cash flows to it. The SPV pur-chases rights to those cash flows by issuing securities.The sponsor ensures that the cash flows arrive.

But if cash f lows are inadequate to meet obligationson the securities, the SPV cannot become legallybankrupt. Instead, it makes principal payments aheadof schedule, but extended over time. An essential fea-ture for an SPV, thenand a source of value to thesponsoring firmis that it is bankruptcy remote.

Vol swapAn abbreviation for volatility swap, a futures con-tract based on the realized volatility of an underlyingasset. In this instance, Gorton is simply providing anexample of a financial instrument that most investorsdont use or understand.

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